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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."

Suggested Citation

  • Carlo Alberto Magni, 2010. "Average internal rate of return and investment decisions: A new perspective," PROYECCIONES FINANCIERAS Y VALORACION 006653, MASTER CONSULTORES.
  • Handle: RePEc:col:000463:006653
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    Keywords

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

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • M10 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Business Administration - - - General
    • M21 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Business Economics - - - Business Economics
    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • N01 - Economic History - - General - - - Development of the Discipline: Historiographical; Sources and Methods

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