Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

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How can the IRR of an investment be misleading?

When cash flows are positive only
When there is only one sign change in cash flows
When there are multiple sign changes
When cash flows remain constant

The correct answer is: When there are multiple sign changes

The internal rate of return (IRR) can indeed be misleading, particularly when there are multiple sign changes in cash flows. This situation arises when an investment has alternating periods of positive and negative cash flows, which can result in multiple IRRs for the same investment. Having multiple sign changes means that the cash flows do not follow a straightforward pattern, complicating the calculation of the IRR. Instead of one unique IRR, there can be multiple rates at which the net present value of those cash flows equals zero. Consequently, investors may struggle to determine the actual profitability of the investment just by looking at the IRR, as they might arrive at different IRR values depending on how they interpret the cash flows. This can lead to confusion and potentially poor investment decisions, as relying solely on one IRR can mask the true financial performance of the investment. In contrast, if cash flows are consistently positive, change signs only once, or remain constant, the situation is much clearer, making the IRR a more reliable measure of performance.