2) You have 3 projects with the following cash flows: Year 0 1 2 3 4 Project 1 -$150 $20 $40 $60 $80 Project 2 -825 0 0 7,000 -6,500 Project 3 20 40 60 80 -245 For which of these projects is the IRR rule reliable?
2) You have 3 projects with the following cash flows: Year 0 1 2 3 4 Project 1 -$150 $20 $40 $60 $80 Project 2 -825 0 0 7,000 -6,500 Project 3 20 40 60 80 -245 For which of these projects is the IRR rule reliable?
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Transcribed Image Text:### Project Cash Flow Analysis
#### You have 3 projects with the following cash flows:
| Year | 0 | 1 | 2 | 3 | 4 |
|-----------|--------|------|-----|--------|--------|
| Project 1 | -$150 | $20 | $40 | $60 | $80 |
| Project 2 | -$825 | $0 | $0 | $7,000 | -$6,500|
| Project 3 | $20 | $40 | $60 | $80 | -$245 |
For which of these projects is the IRR rule reliable?
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In this table, the cash flows for three different projects are detailed across five years (including year 0). Negative values indicate outflows (expenses or investments), and positive values indicate inflows (revenue or returns).
#### Key Points:
- **Project 1** starts with an initial investment of $150 and generates a series of positive cash flows over the subsequent four years.
- **Project 2** has a substantial initial investment of $825 and significant cash flow in year 3, followed by a large negative cash flow in year 4.
- **Project 3** begins with positive cash inflows each year, ending with a significant negative cash flow in year 4.
The reliability of the IRR (Internal Rate of Return) rule depends on how consistent and non-volatile the project's cash flows are over time. It is critical to analyze each project's cash flow pattern to determine where IRR can be a reliable measure.
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It is important to note that the IRR rule tends to be more reliable for projects with conventional cash flow patterns (initial outflow followed by a series of inflows). Non-standard cash flows, like those with alternating positive and negative values, can lead to multiple IRRs or no IRR at all, complicating reliability.
For an educational analysis, students should consider:
- **Consistency of cash flows**
- Potential for multiple IRRs
- Understanding the nature of each project’s financial returns
By scrutinizing these aspects, you can determine which project adheres best to the reliable application of the IRR rule.
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