Question

Which of the following statements are true? The internal rate of return (IRR):

I. rule states that a typical investment project with an IRR that is less than the required rate should be rejected.
II. is the rate generated solely by the cash flows of an investment project.
III. is the rate that causes the net present value of a project to exactly equal zero.
IV. can effectively be used to analyze investment scenarios with any pattern of cash flows.

Answer 1

Statements I, II, and III about the internal rate of return (IRR) are true, while Statement IV is not necessarily true as IRR can be misleading for non-conventional cash flows. The IRR is pivotal for understanding the expected rate of return, risk, and actual rate of return for investments.

Step-by-step explanation:

Regarding the internal rate of return (IRR), the following statements can be verified:

• Statement I is true: The IRR rule suggests that if the IRR on a project is less than the required rate, typically the cost of capital, the project should be rejected because it likely won't cover the cost of financing it or provide an adequate return.
• Statement II is true: The IRR is indeed a rate that is calculated based on the cash flows generated by a specific investment project, without any external factors.
• Statement III is true: The IRR is the discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.
• Statement IV is not necessarily true: IRR can be misleading when used to evaluate projects with non-conventional cash flows, such as those with multiple sign changes (meaning cash flows switch back and forth between positive and negative), as it can result in multiple IRRs, making the analysis inconclusive.

The subject of IRR touches upon concepts such as the expected rate of return, risk, and actual rate of return as these factors are integral when assessing an investment's potential profitability.