K – initial investmentC – return on investment
PV (i) is a decreasing function, i > -1 If i +∞, then PV (i) -K If i -1, then PV (i) +∞ There is a point at which PV (i) = 0. This point is known as IRR. If i > IRR => PV (i) < 0 => CF is not profitable If i < IRR => PV (i) > 0 => CF is profitable Thus, if interest rate on a loan (cost of funds) is less than IRR, the investment is profitable. Possible Problems When a project is an independent project, meaning the decision to invest in a project is independent of any other projects, IRR method will answer either rejecting or accepting a project. However, when IRR is used for analysis of mutually exclusive objects, i.e. when the decision must be one investment project or another – this is not a good method. This is a result of the timing of cash flows for each project. In addition, conflicting results may simply occur because of the project sizes. Other disadvantages: - The method requires an estimate of the cost of capital in order to make a decision - The method cannot be used in situations in which the sign of the cash flows of a project change more than once during the project’s life
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