Correct option is D
The Internal Rate of Return (IRR) method is a widely used capital budgeting technique to evaluate the profitability of an investment or project. Its merits are as follows:
A. Consider all cash flows:
- The IRR method takes into account all cash flows (inflows and outflows) throughout the project's life, making it a comprehensive measure.
C. Generally consistent with the wealth maximization principle:
- IRR is aligned with the objective of maximizing shareholder wealth, as it focuses on the profitability of investments.
D. It considers the time value of money:
- IRR incorporates the time value of money, ensuring that cash flows are discounted appropriately to reflect their value over time.
- B. Satisfies the value additivity principle: This is not true for IRR. IRR does not satisfy the value additivity principle, as combining two projects with different IRRs can lead to incorrect decisions.
- E. It never fails to indicate the correct choice between mutually exclusive projects: This is incorrect because IRR may provide conflicting results when comparing mutually exclusive projects with different cash flow patterns or scales. In such cases, Net Present Value (NPV) is a more reliable method.
Thus, the merits of IRR are A, C, and D only.
Information Booster:Key Merits of IRR:
- Comprehensive: Considers all cash flows.
- Time Value of Money: Discounts future cash flows to their present value.
- Wealth Maximization: Generally aligns with maximizing shareholder wealth.
Limitations of IRR:
- May give multiple IRRs for non-conventional cash flows.
- Misleading for Mutually Exclusive Projects: May conflict with NPV results.
- Does Not Consider Scale of Projects: Fails to differentiate between projects of varying sizes.
Additional Knowledge:
1. Value Additivity Principle:
The Value Additivity Principle means that the value of two projects combined should equal the sum of their individual values. IRR does not satisfy this because it doesn't consider the scale or absolute value of projects. Instead, IRR focuses on percentages, which can lead to errors when combining projects.
2.Correct Choice Between Mutually Exclusive Projects:
IRR can fail to indicate the best choice for mutually exclusive projects, especially when projects differ in scale, timing, or cash flow patterns. For example, a smaller project may have a higher IRR but a lower total return, making NPV the more reliable method in such cases.
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