Average Internal Rate of Return and investment decisions: A new perspective
AbstractThe 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 complete 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’s 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 economic meaning is compelling: it is the project return rate implicitly determined by the market. The traditional IRR notion may be found back as a particular case.
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Bibliographic InfoPaper provided by Universita di Modena e Reggio Emilia, Facoltà di Economia "Marco Biagi" in its series Centro Studi di Banca e Finanza (CEFIN) (Center for Studies in Banking and Finance) with number 10021.
Length: pages 33
Date of creation: Feb 2010
Date of revision:
Decision analysis; investment criteria; capital budgeting; internal rate of return; investment stream; market rate; mean;
Other versions of this item:
- Carlo Alberto Magni, 2010. "Average internal rate of return and investment decisions: A new perspective," PROYECCIONES FINANCIERAS Y VALORACION 006653, MASTER CONSULTORES.
- M41 - Business Administration and Business Economics; Marketing; Accounting - - Accounting - - - Accounting
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
- G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- M52 - Business Administration and Business Economics; Marketing; Accounting - - Personnel Economics - - - Compensation and Compensation Methods and Their Effects
This paper has been announced in the following NEP Reports:
- NEP-ACC-2010-03-06 (Accounting & Auditing)
- NEP-ALL-2010-03-06 (All new papers)
- NEP-PPM-2010-03-06 (Project, Program & Portfolio Management)
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- 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, vol. 142(1), pages 205-210.
- 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) 10061, Universita di Modena e Reggio Emilia, Facoltà di Economia "Marco Biagi".
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