Average Internal Rate of Return and Investment Decisions: A New Perspective

The internal rate of return (IRR) is often used by managers and practitioners for investment decisions. Unfortunately, it has serious flaws: (1) multiple real-valued IRRs may arise; (2) complex-valued IRRs may arise; (3) the IRR is, in general, incompatible with the net present value (NPV) in accept/reject decisions; (4) the IRR ranking is, in general, different from the NPV ranking; (5) the IRR criterion is not applicable with variable costs of capital. The efforts of economists and management scientists in providing a reliable project rate of return have generated over the decades an immense bulk of contributions aiming to solve these shortcomings. This article offers a complete solution to this long-standing unresolved issue by changing the usual perspective: the IRR equation is dismissed and the evaluator is allowed to describe the project as an investment or a borrowing at his discretion. This permits showing that any arithmetic mean of the one-period return rates implicit in a project reliably informs about a project's profitability and correctly ranks competing projects. With such a measure, which we call average internal rate of return, complex-valued numbers disappear and all the above-mentioned problems are wiped out. The economic meaning is compelling: it is the project return rate implicitly determined by the market. The traditional IRR notion may be found as a particular case.     

TECHNICAL NOTE : THE VARIABLE FINANCIAL INDICATOR IRR AND THE CONSTANT ECONOMIC INDICATOR NPV

The IRR (internal rate of return) and the NPV (net present value) are the two most common and important indicators in investment decisions. These two indicators, however, have intrinsic differences between one another. The IRR is a financial indicator and the NPV an economic indicator of a capital investment. The former gives the private investor's point of view and the latter the society's point of view. The value of ERR varies with the change of Financial arrangement of an investment. The NPV, however, does not but remains constant no matter how the financial arrangement changes. This paper uses an illustrative example to show their intrinsic differences and then describes a mathematical proof to substantiate the different natures of IRR and NPV.     

A NEW APPROACH TO DEPRECIATION MEASUREMENT FOR PUBLIC UTILITIES: COMMENT

This paper examines the use of a simple heuristic for evaluating projects. We posit that ranking projects by IRR and rejecting marginal projects can be superior to a NPV rule if 1) project managers have incentives to overstate cash flow forecasts that occur late in a project's life, 2) project rankings determine project acceptance because not all positive NPV project's are accepted, and 3) a project's IRR is greater than the WACC. In these instances, the IRR heuristic undervalues distant cash flows and thus, reduces project managers' incentives to positively bias forecasts.     

A review of: “APPLIED ECONOMIC ANALYSIS FOR TECHNOLOGISTS,ENGINEERS, AND MANAGERS ” BY MICHAEL S. BOWMAN Prentice-Hall,Inc., Upper Saddle River,New Jersey, 1999, xii + 561 pp., ISBN: 0-13-375932-6, List: $76.75.

In their recent paper Tang and Tang (2003 Tang, S. L. and Tang, H. J. 2003. The variable financial indicator IRR and the constant economic indicator NPV.. The Engineering Economist, Vol. 48(No. 1): pp. 69–78. [Taylor &; Francis Online] , [Google Scholar], pp. 69–78) revive a longstanding controversy—net present value (NPV) versus internal rate of return (IRR)—by characterizing the NPV as an economic indicator and the IRR as a financial one. The paper implies that this distinction justifies ranking financial alternatives by ranking their IRRs. In the current article, it is argued that the direct IRR ranking does not necessarily provide the same evaluation environment—and therefore a fair comparison—for each alternative involved, and that the incremental ranking approach is needed to remedy this shortcoming. The article also points out that Tang and Tang's numerical examples of simple projects with one sign change in their cash flow patterns do not address the problem of multiple IRRs, which consequently renders Tang and Tang's ranking approach dysfunctional. It is demonstrated that the concept of a true rate of return, substituting for the non-performing IRR and applied in conjunction with the incremental approach, provides an adequate tool for ranking mutually exclusive projects or a project's technical or financial alternatives.     

A Review of: “An Introduction to Mathematical Finance: Options and Other Topics By Sheldon M. Ross” Cambridge University Press,New York,New York, 1999, xv + 184 pp. ISBN ( 521-77043-2. List: $37.95. (hardback)

Surveys of businesses' capital budgeting practices reveal that the IRR is much preferred over the NPV as an investment decision making tool even though business scholars prescribe the NPV as theoretically optimal. Here practitioners' preference for the IRR is explained through ergonomics: the IRR is treated as a display method. As such it is more compatible with decision makers' expectations and therefore, is more cognitively efficient. Because the IRR is expressed as an interest rate, it more closely resembles an analog display, in which the IRR is simply compared to the required return. In contrast, the NPV is stated in dollars, resembling more a very precise digital display. Academicians should reorient their efforts from promoting the NPV to teaching methods to ameliorate the pitfalls of the IRR.     

The Internal Rate of Return Approach and the AIRR Paradigm: A Refutation and a Corroboration

This article shows that the internal rate of return (IRR) approach is unreliable and that the recently introduced average internal rate of return (AIRR) model constitutes the basis for an alternative theoretical paradigm of rate of return. To this end, we divide the paper into two parts: a pars destruens and a pars construens. In the “destructive” part, we present a compendium of 18 flaws associated with the IRR approach. In the “constructive” part, we construct the alternative approach from four (independent) economic intuitions and put the paradigm to the test by showing that it does not suffer from any of the flaws previously investigated. We also show how the IRR, as a rate of return, is absorbed into the new approach.     

PREPAYMENT OF INCOME TAX: A “SPREADSHEET” ANALYSIS

In their recent paper ( D. Asquith &; J.E. Bethel, “Using Heuristics to Evaluate Projects: The Case of Ranking Projects by IRR,” The Engineering Economist, Vol. 40, No. 3 (Spring 1995, pp. 287-294) ), the authors propose a project ranking procedure that is supposed to mitigate the impact of cash flow overvaluation by project managers. In the current contribution, it is indicated that this procedure is based upon a project ranking approach that employs the IRR criterion in a theoretically inadequate way. The correct, incremental approach to the IRR-based project ranking is reiterated, and it is shown that if this approach is applied, then its very design reduces the impact of CF-biases on project ranking. It is also demonstrated that even if competing projects are of equal scale, they must still be ranked by incremental comparison. Finally, it is pointed out that the incremental project ranking is the proper approach regardless of which NPV-compatible profitability measure is applied.     

投资项目财务评价内部收益率的比较研究

投资项目财务评价是可行性研究报告的核心内容之一,而内部收益率是判断项目财务可行性和预期盈利能力的主要指标。从内部收益率的经济含义入手,分析了项目投资内部收益率、项目资本金内部收益率和投资各方内部收益率3类内部收益率的适用条件和数量关系,认为项目投资内部收益率是项目融资前决策的首选指标,且只需计算所得税前指标;资本金内部收益率是项目融资决策分析的主要指标,当项目投资内部收益率大于银行利率时,资本金内部收益率大于项目投资内部收益率;当各股东（投资方）同股非同权或存在股权之外的收益分配时,需要计算投资各方内部收益率。     

Managerial Advantages of using Payback as a Surrogate for NPV

Existing literature identifies specific situations in which payback methods (PB) can provide precise surrogates for NPV analyses of accept/reject decisions. This paper extends that literature to take explicit account of taxation and of ranking decisions using profitability indices. Nevertheless, NPV can be considered preferable to PB as a basis for maximising stockholder wealth (MSW), because it requires fewer assumptions and provides more information. Yet simple PB continues to be used extensively, which suggests that it has advantages for decision-makers. Some authors suggest that its use reflects managerial short-termism and is inconsistent with MSW. In contrast, this paper proves that (with standard patterns of cash flows, defined risk classes and asymmetrical information) the use of PB instead of NPV should motivate risk-averse subordinate managers to adopt more positive NPV projects. Consequently, the appropriate use of PB can result in more wealth for stockholders than would occur using NPV directly. Furthermore, the use of PB avoids a number of costs and in the appropriate circumstances may therefore be the most cost-effective basis for evaluating investment decisions.     

The IRR of a project with many potential outcomes

This article shows that the internal rate of return (IRR) of a project's expected cash flow stream is a weighted average of the IRRs offered by the project's (many) possible future outcomes, where the weights are calculated using the outcome probabilities and invested capital balances. Because the invested capital associated with a particular realization is a function of the Macaulay duration of the cash flows in that outcome, the weights depend on the outcome probabilities and the effective length of each cash flow stream.     

Double vision: Insights about the origin and interpretation of multiple IRRs

The ability of a project's internal rate of return (IRR) to quantify its economic return has been questioned by many scholars over the past 60 years, most recently by Magni (2010 Magni, C.A. (2010) Average internal rate of return and investment decisions: a new perspective. The Engineering Economist, 55(2), 150–180. [Google Scholar], 2013 Magni, C.A. (2013) The internal rate of return approach and the AIRR paradigm: a refutation and a corroboration. The Engineering Economist, 58(2), 73–111. [Google Scholar]). Although IRR is a plausible—albeit imperfect—measure of a project's economic return when the cash flow stream is conventional, IRR can be an untenable measure of an unconventional project's economic return. The goal of this article is to identify a simple, intuitive explanation of IRR, one that can be applied to any cash flow pattern. To do this, the article shows how a project's IRR systematically changes when it first crosses from the conventional into the unconventional realm (i.e., a small cash outflow is appended to a conventional cash flow stream) and then as it becomes progressively more unconventional. This process reveals that the most robust economic interpretation of IRR—for both conventional and unconventional projects—is that a project's IRRs are external benchmarks that divide the set of all plausible discount rates into positive and negative net present value (NPV) ranges, rather than internally generated returns. Because it can be difficult to estimate a project's cost of capital with precision, this information can help guide the sensitivity analysis of a project.     

Is There A “New” Internal Rate of Return Literature?

Recent writing in various real estate journals appears to have become interested in an issue which a number of other journals have treated previously. Specifically, the concept known as the internal rate of return (IRR) has been examined extensively by the literatures of business finance, management science, and economic theory. This paper surveys and reviews the literature by problem, journal and date. The paper concludes that this demonstration suggests the necessity of an understanding of literature in related disciplines as well as our own.     

A note on the sensitivity analysis of the internal rate of return

In this note we discuss the sensitivity analysis of the internal rates of return (IRR). We show that the use of partial derivatives can be misleading in the identification of key drivers of an investment project's performance. To remedy this shortcoming, we propose the use of an alternative sensitivity measure called the Differential Importance Measure. The analysis shows that, even if the theoretical conditions for using the Net Present Value or the IRR as valuation criteria apply, the sensitivity analysis results for the two indicators may differ.     

东北某探区油页岩资源开发项目经济评价

油页岩资源经济评价的主要任务是评价油页岩开发建设项目的经济可行性,常用的评价方法有静态法和动态法两种,关键指标有财务内部收益率、投资回收期、净现值和现值指数等。文章以东北某探区油页岩开发项目为例,采用动态评价方法对该项目的经济可行性进行了研究,并具体介绍了相关指标的选取方法,对于提高油页岩开发项目经济评价的准确性和决策效率有一定的参考作用。     

我国跨境油气管道管输费制定模式

从中亚、中哈和中俄陆上油气管道的管输费制定模式上可以看出,管输费的制定并没有统一的模式,但都符合成本回收和投资回报的基本原则;管输费的制定应充分考虑管道所在国政府的相关管理规定,并按照其管输费制定模式对国际通用的财务内部收益率（IRR）方法进行调整。在对外合作项目的商务交流活动中,谈判需要一定的灵活性,不宜一味坚持国内适用的财务内部收益率法的管输费制定模式。建议国内相关部门和单位,参照已经运行的跨境管道的管输费制定模式,对今后海外管道项目的经济评价和管输费制定公式进行调整与完善,以便更好地适应对外项目合作的需要。     

PERPETUITY RATE OF RETURN ANALYSIS

This paper introduces a new method of capital project analysis called the perpetuity rate of return (PRR). As implied by its name, the PRR is found by transforming a project's cash flow stream into a perpetuity and then relating this value to the required investment outlay. The PRR method is essentially a compromise between the NPV and IRR techniques. Like the NPV, the PRR correctly values a project's cashflows by using the market-determined cost of capital as the discount rate; like the IRR, the PRR is a rate of return that is appropriately compared to the cost of capital to determine a project's acceptability. The new yield-based method fares well in comparison with the IRR on a conceptual level and appears to have practical potential.     

PCA在大型工程目标集成化动态分析上的应用

质量、费用及工期是大型工程项目管理的三大控制对象,通过建立大型工程项目质量、费用和工期的指标体系,利用多元统计分析中的PCA,将影响大型工程项目质量、费用和工期目标的17个因素进行降维处理,得到6个主成分,计算并比较6个主成分特征向量绝对值的大小进行重新归类,对比归类后的6个主成分得分排名和综合评价得分排名,进行大型工程目标集成化动态分析。最终案例分析的结果表明,结论符合实际大型工程项目管理的可能情况。     

NOTE ON “EQUIVALENCE OF CASH FLOWS WHEN COMPOUNDING OCCURS LESS FREQUENTLY THAN THE CASH FLOWS”

The present worth (PW) and future worth (FW) decision criteria are to be found in virtually all current engineering economy textbooks. Although the relationships between the internal rate of return (IRR) criterion and PW has been widely discussed in the literature, there remains some misunderstanding as to similar relationships between PW and FW. Of particular importance is the interest rates at which PW and FW are maximized. It is shown here that the maximizing rates are not necessarily equal. This leads to the seemingly peculiar result that a change in the discount rate may decrease the PW while at the same time increasing the FW, or vice versa. Numerical, mathematical and intuitive arguments are presented.     

Duration and relational choices: Time based effects of customer performance and environmental uncertainty on relational choice

This paper investigates the influences of customer performance and environmental uncertainty on the customer's choice of relational exchange strategies over the duration of their relationship. Relational exchanges of short, intermediate, and long term duration are investigated with the results showing different performance outcomes and environmental factors impacting relational choice at different times in the relationship. The results help explain conflicts reported in prior relational exchange research and provide valuable insights for practitioners responsible for managing relational exchanges.     

A Review of: ADVANCED TECHNIQUES FOR STRATEGIC PLANNING by Ernest C. Miller

The Net Present Value (NPV) rule of financial theory gives management a decisive criterion for choosing between abandonment versus continuation of capital projects. There is extensive evidence, however, that management chooses to delay the abandonment of unprofitable projects. This paper attempts to explain management's reluctance to abide by the NPV criterion. The concept of a Reputation Adjusted Net Present Value is introduced in an environment where management knows more about the true value of a project than do stakeholders. The model indicates that, in such an environment, the continuation of a negative NPV project may maximize firm value.