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Average internal rate of return and investment decisions: A new perspective

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  • Carlo Alberto Magni

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Abstract

The internal rate of return (IRR) is often used by managers and practitioners for investment decisions. Unfortunately, it has serious flaws: (i) multiple real-valued IRRs may arise, (ii) complex-valued IRRs may arise, (iii) the IRR is, in general, incompatible with the net present value (NPV) in accept/reject decisions (iv) the IRR ranking is, in general, different from the NPV ranking, (v) 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 paper offers a solution to this long-standing 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 to show that any arithmetic mean of the one-period return rates implicit in a project reliably informs about a project profitability and correctly ranks competing projects. With such a measure, which we name Average Internal Rate of Return"), complex-valued numbers disappear and all the above mentioned problems are wiped out. The traditional IRR notion may be found back as a particular case.*This article has been selected for the Grant award, given annually by the Engineering Economy Division of the American Society for Engineering Education to the author of the best paper in the journal The Engineering Economist. The papers was judged based on its originality, importance of the problem, logic and clarity, and adequacy of proposed solution. This award is named after Eugene L. Grant, a professor at Stanford."

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Bibliographic Info

Paper provided by MASTER CONSULTORES in its series PROYECCIONES FINANCIERAS Y VALORACION with number 006653.

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Length: 25
Date of creation: 31 Jan 2010
Date of revision:
Handle: RePEc:col:000463:006653

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Keywords: Capital budgeting; decision analysis; investment criteria; internal rate of return; investment stream; mean;

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Cited by:
  1. Pasqual, Joan & Padilla, Emilio & Jadotte, Evans, 2013. "Technical note: Equivalence of different profitability criteria with the net present value," International Journal of Production Economics, Elsevier, Elsevier, vol. 142(1), pages 205-210.
  2. Magni, Carlo Alberto, 2013. "Generalized Makeham’s formula and economic profitability," Insurance: Mathematics and Economics, Elsevier, Elsevier, vol. 53(3), pages 747-756.
  3. C. Pederzoli & C. Torricelli, 2013. "Efficiency and unbiasedness of corn futures markets: new evidence across the financial crisis," Applied Financial Economics, Taylor & Francis Journals, Taylor & Francis Journals, vol. 23(24), pages 1853-1863, December.
  4. Chiara Pederzoli & Costanza Torricelli, 2010. "A parsimonious default prediction model for Italian SMEs," Centro Studi di Banca e Finanza (CEFIN) (Center for Studies in Banking and Finance), Universita di Modena e Reggio Emilia, Facoltà di Economia "Marco Biagi" 10061, Universita di Modena e Reggio Emilia, Facoltà di Economia "Marco Biagi".
  5. Sorda, G. & Sunak, Y. & Madlener, R., 2013. "An agent-based spatial simulation to evaluate the promotion of electricity from agricultural biogas plants in Germany," Ecological Economics, Elsevier, Elsevier, vol. 89(C), pages 43-60.
  6. Stefano Cosma & Elisabetta Gualandri, 2013. "The sovereign debt crisis: the impact on the intermediation model of Italian banks," Centro Studi di Banca e Finanza (CEFIN) (Center for Studies in Banking and Finance), Universita di Modena e Reggio Emilia, Facoltà di Economia "Marco Biagi" 13102, Universita di Modena e Reggio Emilia, Facoltà di Economia "Marco Biagi".
  7. Vélez Pareja Ignacio, 2012. "Ranking and optimal selection of investments with internal rate of return and benefit-cost ratio: a revision," Contaduría y Administración:Revista Internacional, Accounting and Management: International Journal, Accounting and Management: International Journal, vol. 57(1), pages 29-51, enero-mar.
  8. Elisabetta Gualandri & Valeria Venturelli, 2013. "The financing of Italian firms and the credit crunch: findings and exit strategies," Centro Studi di Banca e Finanza (CEFIN) (Center for Studies in Banking and Finance), Universita di Modena e Reggio Emilia, Facoltà di Economia "Marco Biagi" 13101, Universita di Modena e Reggio Emilia, Facoltà di Economia "Marco Biagi".

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