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ACCA Applied Knowledge · Management Accounting · Asset budgeting and investment appraisal

Which of the following is a recognised limitation of using IRR to choose between mutually exclusive projects?

IRR can rank mutually exclusive projects differently from NPV because it is a percentage and ignores the size of the investment. A smaller project with a higher IRR may add less absolute value than a larger one, so NPV is the preferred decision criterion.

  1. AIt can give a ranking that conflicts with NPV, because it is a percentage and ignores the scale of the investmentCorrect
  2. BIt ignores the time value of money
  3. CIt ignores all cash flows that occur after the payback period
  4. DIt can only be used when cash flows arise in equal annual amounts

Explanation

IRR is a relative measure, so a small project with a high IRR may rank above a larger one that adds more absolute wealth (higher NPV). IRR does consider the time value of money. Ignoring cash flows after payback is a weakness of payback, not IRR. IRR can be calculated for uneven cash flows.

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