Final answer:
The internal rate of return (IRR) approach to capital project evaluation has several disadvantages, including multiple IRRs, the reinvestment assumption, and the lack of consideration for the size and scale of projects.
Step-by-step explanation:
The internal rate of return (IRR) approach to capital project evaluation has several disadvantages:
- Multiple IRRs: One of the main disadvantages of the IRR approach is the possibility of multiple IRRs. This occurs when there are multiple changes in the cash flow pattern, such as alternating periods of positive and negative cash flows. The presence of multiple IRRs makes it difficult to determine the true rate of return.
- Reinvestment assumption: The IRR approach assumes that cash flows generated by the project can be reinvested at the project's internal rate of return. However, this may not be realistic in practice, as finding investments with the same rate of return can be challenging. This assumption can lead to inaccurate results.
- Size and scale of projects: The IRR approach does not consider the size and scale of projects. It only focuses on the rate of return, which may not provide a comprehensive evaluation of large, long-term projects.