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Which disadvantage of IRR is most critical when comparing projects of different durations?



a.) IRR assumes reinvestment at the IRR rate.

b.) IRR cannot be used for independent projects.

c.) IRR ignores project scale and duration.

d.) IRR requires complex calculations.

Verified Answer :

Final answer:

The most critical disadvantage of IRR when comparing projects of different durations is that it ignores project scale and duration. This can lead to poor investment decisions as it may favor projects that are shorter but less profitable. A comprehensive evaluation requires considering the total cash flows of each project, not just the IRR.


Explanation:

Understanding the Disadvantages of IRR

The Internal Rate of Return (IRR) is a popular method for evaluating the profitability of investments. However, when comparing projects of different durations, one disadvantage that stands out is:

  1. IRR ignores project scale and duration.

This disadvantage means that IRR may lead to misleading conclusions when projects vary significantly in their timeframes. For instance, a project with a high IRR but a shorter duration may actually generate less overall profit compared to a project with a lower IRR that spans a longer duration. Therefore, relying solely on IRR can be problematic because it does not take into account how long the project lasts or its total cash flow, which are crucial for making informed investment decisions.

Other options such as assuming reinvestment at the IRR rate (option a) and requiring complex calculations (option d) are indeed issues but they do not uniquely affect the comparison of projects with differing durations.


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