When a firm evaluates all of its projects by applying the Internal Rate of Return (IRR) rule, which of the following is a potential drawback of this approach?

• A. It ignores the time value of money.
• B. It always provides the same ranking of projects as the Net Present Value (NPV) rule.
• C. It cannot be used for any project with positive cash flows.
• D. It may lead to incorrect decisions when projects differ in scale or timing of cash flows.

Answer: (D)

Verified step by step guidance

1. Understand the Internal Rate of Return (IRR) rule: IRR is the discount rate that makes the Net Present Value (NPV) of a project equal to zero. It is used to evaluate the profitability of potential investments.
2. Recall that the IRR rule assumes that all projects are independent and that cash flows are reinvested at the IRR itself, which may not always be realistic.
3. Recognize that the IRR rule can sometimes give conflicting rankings compared to the NPV rule, especially when projects differ in scale (size of investment) or timing (when cash flows occur).
4. Analyze why differences in scale or timing affect IRR: A project with a higher IRR but smaller scale might be less valuable in absolute terms than a larger project with a lower IRR but higher total NPV.
5. Conclude that relying solely on IRR can lead to incorrect decisions because it may not properly account for the magnitude and timing of cash flows, unlike the NPV rule which directly measures added value.