A weakness of the internal rate of return method for screening investment projects is that it

When evaluating potential capital investments by your small business in various projects, the Internal Rate of Return, or IRR, can be a valuable tool in assessing the projects most worth pursuing. IRR measures the rate of return of projected cash flows generated by your capital investment. The IRR for each project under consideration by your business can be compared and used in decision-making.

Internal rate of return is measured by calculating the interest rate at which the present value of future cash flows equals the required capital investment. The advantage is that the timing of cash flows in all future years are considered and, therefore, each cash flow is given equal weight by using the time value of money.

The IRR is an easy measure to calculate and provides a simple means by which to compare the worth of various projects under consideration. The IRR provides any small business owner with a quick snapshot of what capital projects would provide the greatest potential cash flow. It can also be used for budgeting purposes such as to provide a quick snapshot of the potential value or savings of purchasing new equipment as opposed to repairing old equipment.

In capital budgeting analysis, the hurdle rate, or cost of capital, is the required rate of return at which investors agree to fund a project. It can be a subjective figure and typically ends up as a rough estimate. The IRR method does not require the hurdle rate, mitigating the risk of determining a wrong rate. Once the IRR is calculated, projects can be selected where the IRR exceeds the estimated cost of capital.

A disadvantage of using the IRR method is that it does not account for the project size when comparing projects. Cash flows are simply compared to the amount of capital outlay generating those cash flows. This can be troublesome when two projects require a significantly different amount of capital outlay, but the smaller project returns a higher IRR.

For example, a project with a $100,000 capital outlay and projected cash flows of $25,000 in the next five years has an IRR of 7.94 percent, whereas a project with a $10,000 capital outlay and projected cash flows of $3,000 in the next five years has an IRR of 15.2 percent. Using the IRR method alone makes the smaller project more attractive, and ignores the fact that the larger project can generate significantly higher cash flows and perhaps larger profits.

The IRR method only concerns itself with the projected cash flows generated by a capital injection and ignores the potential future costs that may affect profit. If you are considering an investment in trucks, for example, future fuel and maintenance costs might affect profit as fuel prices fluctuate and maintenance requirements change. A dependent project may be the necessity to purchase vacant land on which to park a fleet of trucks, and such cost would not factor in the IRR calculation of the cash flows generated by the operation of the fleet.

Although the IRR allows you to calculate the value of future cash flows, it makes an implicit assumption that those cash flows can be reinvested at the same rate as the IRR. That assumption is not practical as the IRR is sometimes a very high number and opportunities that yield such a return are generally not available or significantly limited.

37.A weakness of the internal rate of return method for screening investmentprojects is that it: (E)A.does not consider the time value of moneyB.implicitly assumes that the company is able to reinvest cash flows from theproject at the company's discount rateC.implicitly assumes that the company is able to reinvest cash flows from theproject at the internal rate of returnD.fails to consider the timing of cash flowsNet Investment167.The Forest Company is planning to invest in a machine with a useful life offive years and no salvage value. The machine is expected to produce cash flowfrom operations, net of income taxes, of P20,000 in each of the five years.Forest's expected rate of return is 10%. Information on present value and futureamount factors is as follows.P E R I 0 D12345Present value of P1 at 10%.909.826.751.683.621Present value of an annuity of P1at 10%.9091.7362.4873.1703.791Future amount of P1 at 10%1.1001.2101.3311.4641.611Future amount of an annuity ofP1 at 10%1.002.1003.3104.6416.105How much will the machine cost?

A.P32,220C.P 75,820B. P62,100D. P122,100168.Gene, Inc. invested in a machine with a useful life of six years and no salvagevalue. The machine was depreciated using the straight-line method. It wasexpected to produce annual cash inflow from operations, net of income taxes, ofP2,000. The present value of an ordinary annuity of P1 for six periods at 10% is4.355. The present value of P1 for six periods at 10% is 0.5464. Assuming thatGene used a time adjusted rate of return of 10%, what was the amount of theoriginal investment?A.P5,640C. P9,000B. P8,710D. P11,280169.Fordem Co. is considering an investment in a machine that would reduceannual labor costs by P30,000. The machine has an expected life of 10 yearswith no salvage value. The machine would be depreciated according to thestraight-line method over its useful life. The company’s marginal tax rate is 30%.Assume that the company will invest in the machine of it generates a pre-taxinternal rate of return of 16%. What is the maximum amount the company canpay for the machine and still meet the internal rate of return criterion?A.P180,000C. P187,500B. P210,000D. P144,996Unit sales42.King of Kings Company has been renting equipment during peak season inaddition to its own equipment in handling standard materials. The rental costaverages P9,000 a year. The company's Investment Committee is evaluating thepossibility of buying additional equipment at a cost of P225,000 with anestimated useful life of 5 years and with no salvage value at the end of 5 years.The committee estimates that it can save P0.25 per unit of material by using itsown equipment. Also, it estimates that 270,000 units can be handled \n each ofthe 5 years, A 15% discounted rate of return is considered appropriate, ignoringincome tax. Present value of annuity of 1, at 15% for 5 years, is 3,352.What is the approximate number of units at which the investment can just meetthe 15% return requirement? (D)A.232,496C. 304,496B. 268,496D. 256,428Selling price