IRR

CFA Level I Corporate Finance
#1

Hey everyone,

Hope this finds you well.

I have a query regarding IRR and its substance.

We can use IRR to estimate the profitability of the potential investment. I.e we have $100 and a project with the following cash flows.

year 0 - (100), year 1 - 20, year 2 - 30, year 3 - 30, year 4 - 40.

IRR of the project 6,96% and we can say that the profitability of the project is 6,96%. When I’m saying it, I expect that if I invest in year 0 $100 at rate 6,96% compounded annually I would earn the same amount as the potential investment project. But it doesn’t work out this way.

Could you please explain what’s flawed with the logic above and why?

#2

What do you mean when you write, “But it doesn’t work out this way.”? What makes you think that it doesn’t?

#3

If I’m reading your words correctly, I believe that its saying that the IRR reinvestment assumption is unrealistic. IRR is mainly used to discount expected future cash flows. One of the weaknesses of the IRR is that it assumes that you can reinvest your returns at this rate (when it’s actually more realistic to reinvest at the cost of capital).