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CFA Level I · CFA Level I Exam · Capital Investments and Capital Allocation

A company's analyst bases the capital budget on the project's IRR and finds the IRR exceeds the cost of capital. Which pitfall is most likely if the analyst ranks mutually exclusive projects of very different size only by IRR?

The most likely pitfall is accepting a smaller project that adds less value. IRR is a rate that ignores project scale, so it can favor a small, high-IRR project over a larger one with greater NPV, which is the better measure of shareholder wealth created.

  1. AAccepting a smaller project that adds less value than a larger oneCorrect
  2. BOverstating the project's cost of capital
  3. CDouble counting the sunk costs of the project

Explanation

IRR is a percentage and ignores scale, so a small project with a high IRR can rank above a larger one with a lower IRR but a larger NPV. This leads to choosing the option that adds less shareholder wealth. IRR ranking has no direct link to the cost of capital or sunk costs.

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