Project Moon has a higher IRR than Project Sun. The following explanation best describes why you should be careful when using IRR as the main decision criteria to decide between Project Sun and Project Moon.

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BlackTom AI · Accepted Answer

When evaluating two projects, it's important to recognize that a higher IRR does not always translate into the best economic value, especially if the projects are mutually exclusive.

First, consider the core idea behind IRR: it is the discount rate that makes the net present value (NPV) of a project's cash flows equal to zero. A higher IRR suggests a higher percentage return, but it does not account for the scale of the investment. If Project Moon requires a much larger initial outlay or yields smaller absolute cash inflows than Project Sun, Moon could still destroy more value overall even with a higher IRR.

Second, IRR assumes that intermediate cash flows are reinvested at the same rate as the IRR. In practice, this reinvestment rate is unlikely to match the project’s internal rate of return, which can distort the attractiveness of a project relative to using NPV, which uses a more realistic cost of capital as the reinvestment rate.

Third, for mutually exclusive projects, the decision criterion should generally be based on NPV rather than IRR because NPVs are additive and directly measure value creation in currency terms. A higher IRR for one project may come with a lower NPV than the alternative, meaning one project creates less value overall despite a higher percentage return.

Finally, timing and scale differences between Sun and Moon can influence the outcome. A project with earlier cash flows or larger scale may produce a higher NPV even if its IRR is lower, due to the time value of money and capital costs.

In light of these points, relying solely on IRR to choose between mutually exclusive projects can lead to the wrong decision. The statement correctly cautions that using IRR as the main decision criterion is potentially misleading because it ignores scale, timing, reinvestment assumptions, and overall value.

Note: If only one option is available, this reasoning implies why that option’s claim remains a valid caution about IRR and why blind preference for the higher IRR can be dangerous without considering NPV and other factors.

COMM_V 298 201-207 2024W2 Class 16: Capital Budgeting Practice Quiz 1

Project Moon has a higher IRR than Project Sun. The following explanation best describes why you should be careful when using IRR as the main decision criteria to decide between Project Sun and Project Moon.

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