Internal Rate of Return Rule Flaws: Why It's Not Always Reliable

The internal rate of return (IRR) rule is a common tool used in investment analysis to determine the profitability of a project. However, it's important to understand that the IRR rule has two fatal flaws that can lead to incorrect decisions:

1. Arbitrary determination of a discount rate: The IRR calculation requires a discount rate, which represents the minimum rate of return required for an investment to be considered acceptable. This discount rate is often subjectively determined and can vary significantly depending on the investor's risk tolerance and market conditions.

2. Failure to correctly analyze mutually exclusive investment projects: The IRR rule can be misleading when comparing mutually exclusive projects, meaning projects where only one can be chosen. This is because the IRR rule only considers the rate of return of each project individually, not their relative profitability.

Therefore, it's crucial to be aware of these limitations and consider alternative investment analysis methods to avoid making biased decisions based on IRR alone.