Reference no: EM131189164
Let’s try to examine the most glaring issue with IRR via an example. Let’s suppose a friend of yours offers you an "investment." He knows that every year there is one day when some lottery numbers are fixed. Based on his insider knowledge, if you invest $2 with him, he will return you $100 at the end of each of the next two years by matching lottery numbers.
a. First, calculate the IRR for this project. Since you're turning $2 into at least $200 in just two years, this should be a very high percentage. Call the IRR percentage r.
b. Next, calculate how much you might expect to earn from this project (i.e, the future value). Let's assume you're an ordinary investor and can, under normal circumstances, earn an interest rate of 5% on cash you have on hand.
c. Let's say you find a super-secret-awesome bank account that offers 1000% interest. If you put your $2 into this account, how much will you have at the end of 2 years?
d. In the module, it was discussed that, generally, if the discount rate is less than the IRR then a project should be accepted. And yet, even though our IRR from part (a) is greater than 1000%, the amount earned in part (c) is more than in part (b). Explain why our rule of thumb doesn't apply, and why IRR is not a perfect measure of an investment.
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