Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

When an investment shows two solutions for its IRR, what does that indicate?

1. There is a consistent cash flow stream

2. There is one sign change in the cash flow

3. There are two sign changes in the cash flow stream

4. Cash flows are linear

The correct answer is: There are two sign changes in the cash flow stream

When an investment shows two solutions for its Internal Rate of Return (IRR), it indicates that there are two sign changes in the cash flow stream. This phenomenon typically arises in scenarios where an investment has multiple cash flow periods with varying signs, such as alternating positive and negative cash flows. The IRR is the rate at which the net present value (NPV) of all cash flows (both incoming and outgoing) equals zero. When cash flows switch signs more than once—meaning there is a sequence of negative cash flows followed by positive cash flows, or vice versa—this can lead to multiple IRR solutions. Each set of cash flows creates a different rate that equates the present value of inflows to outflows at different points, resulting in multiple IRR values. Understanding this behavior is important for investors, as it complicates the interpretation of IRR and may suggest that additional metrics or analyses are necessary to evaluate the investment's profitability accurately. This stands in contrast to scenarios with consistent cash flows or only one sign change, where typically only one IRR exists, providing a clear and straightforward metric for analysis.