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3 key pitfalls of IRR revolve around cashflow sign
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Delayed Investments
- For most investment opportunities, expenses occur in the early part and cash-in received after the investment. When the net cash flow has cash-in reversed i.e. receiving them in the beginning and the cash-out after that, it is akin to a borrowing. When this happen IRR will give misleading insight, because when you borrow money you prefer as low a rate as possible.
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Multiple IRRs
- Calculation of IRR depended on the net cash flow having an investment “period” and income “period” – as represented in cumulative net cash flow. If the cumulative NCF crosses the zero-line more than once, there can be a case of multiple IRR. In general, there can be as many IRRs as the number of times the project’s cash flows change sign over time.
- this is due to IRR calculation finds the discount rate that makes total positive NCF equals to total negative NCF. When there is a significant series of positive NCF before an investment “period”, this creates a series of lending and borrowing – each will fight for the discount rate to be on the polar opposite
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Nonexistent IRR
- if the opposite cashflow is non-significant there will be no discount rate that makes the NPV equal to zero
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Metadata
- topic:: 00 Engineering Economics00 Engineering Economics
#MOC / for economics notes with focus on petroleum fiscal and engineering
- updated:: 2022-01-12 Private or Broken Links
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- reviewed:: 2022-01-12 Private or Broken Links
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