The Internal Rate of Return (IRR) can sometimes provide misleading recommendations, particularly in cases with unconventional cash flows (multiple sign changes). Here’s a breakdown of each scenario to identify when IRR would recommend the wrong decision:
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Starting cash flow: -100,000 Ending cash flow: 110,000
- This represents a straightforward investment: you invest $100,000 and receive $110,000 back at some point. The IRR would likely be positive, indicating a good investment.
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Starting cash flow: 1000 Ending cash flow: -2000
- This represents a cash outflow of $1,000 in the beginning and a cash inflow of -$2,000 later on (which is essentially a loss). The IRR explanation here is tricky; the IRR may incorrectly suggest you are generating a return, even though you are essentially losing money.
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Starting cash flow: -100 Ending cash flow: +200
- This is also a straightforward investment scenario where you invest $100 to receive $200 back, which would generate a positive IRR.
Based on the analysis, the scenario where the IRR would likely recommend the wrong decision is:
Starting cash flow: 1000 Ending cash flow: -2000
This scenario could lead to an IRR that inaccurately reflects the effectiveness of the investment since you are losing money overall. The IRR may suggest that the return is positive when, in fact, the cash outflows lead to a net loss.