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On the bias of yield-based capital budgeting methods

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Author Info
Olivier Rousse () (LASER-CREDEN, Faculty of Economics, University of Montpellier 1)

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Abstract

The aim of this paper is twofold. First, we present a new capital budgeting method, called the real rate of return (RRR), which has been developed for solving the inconsistency of the modified internal rate of return (MIRR) with shareholders' wealth maximization when costs of capital differ between projects. After surveying the merits of this method over the MIRR, we focus our attention on another interesting feature of the RRR when cash flows are uncertain. We compare the RRR bias with the MIRR bias and demonstrate that the RRR bias is inferior to the MIRR bias. This theoretical finding confirms once again that the RRR is a better capital budgeting method than the MIRR. Knowing that managers exhibit in practice a large preference for comparing the merits of projects with rates of return, this simple and flexible yield-based capital budgeting method has all the qualities to be accepted in practice.

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File URL: http://economicsbulletin.vanderbilt.edu/2008/volume7/EB-08G30001A.pdf
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Publisher Info
Article provided by Economics Bulletin in its journal Economics Bulletin.

Volume (Year): 7 (2008)
Issue (Month): 9 ()
Pages: 1-8
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Handle: RePEc:ebl:ecbull:v:7:y:2008:i:9:p:1-8

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Related research
Keywords: Capital budgeting; modified internal rate of return; real rate of return; bias.;

Find related papers by JEL classification:
G3 - Financial Economics - - Corporate Finance and Governance

References listed on IDEAS
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  1. repec:mop:credwp:08.02.73 is not listed on IDEAS
  2. Dirk Brounen & Abe de Jong & Kees Koedijk, 2004. "Corporate Finance in Europe: Confronting Theory with Practice," Financial Management, Financial Management Association, vol. 33(4), Winter.
  3. McDaniel, William R & McCarty, Daniel E & Jessell, Kenneth A, 1988. "Discounted Cash Flow with Explicit Reinvestment Rates: Tutorial and Extension," The Financial Review, Eastern Finance Association, vol. 23(3), pages 369-85, August.
  4. Brounen, D. & Jong, A. de & Koedijk, C.G., 2004. "Corporate Finance In Europe Confronting Theory With Practice," Research Paper ERS-2004-002-F&A Revision, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus Uni. [Downloadable!]
  5. Graham, John R. & Harvey, Campbell R., 2001. "The theory and practice of corporate finance: evidence from the field," Journal of Financial Economics, Elsevier, vol. 60(2-3), pages 187-243, May. [Downloadable!] (restricted)
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This page was last updated on 2009-12-12.

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