BUSF_A01.qxd

Internal rate of return

However, now consider the following two projects:

Cash flows

Year Project C Project D

££

0 (10,000) 10,000

1 33,000 (16,000)

2 (24,000) 12,000

Both of these projects are unconventional in that they each have two changes of sign

in the cumulative cash flows. Project C changes from negative to positive between

years 0 and 1 and from positive to negative between years 1 and 2. Project D does pre-

cisely the opposite.

The graphs of NPV against discount rate for each of these unconventional projects

are shown in Figures 4.2 and 4.3. Project C has two IRRs (8 per cent and 122 per cent),

both of which are equally correct. Which of these should be taken as being the appro-

priate one for investment decisions? There is no answer to this question and so here

IRR gives an ambiguous result. NPV can be used though: with any cost of finance

between 8 per cent and 122 per cent the project is favourable; if the business’s cost of

finance is below 8 per cent or above 122 per cent the project should be rejected.

Trying to find the IRR of Project D by trial and error would be a frustrating

experience because there simply is not one, at least not a real one. The graph shows

there to be no intercept between the horizontal axis and the curve. Once again, IRR

is incapable of assessing the project despite the fact that it has a large NPV at all dis-

count rates.

Figure 4.2
Graph of the NPV
against the discount
rate for Project C

The particular features of the cash flows of this project lead to its having two IRRs.