Rehabilitation of the Internal Rate of Return
15 Pages Posted: 26 Jun 2020
Date Written: May 5, 2020
The Internal Rate of Return (IRR) is a widely used investment performance measure. However, due to well-known pitfalls and wrong assumptions rather attributed than inherent in the IRR technique some experts on capital budgeting recommend either using the IRR rule very carefully or avoiding it entirely. The paper discusses the most significant pitfalls concerning the IRR in some cases appear to be common misconceptions, while the actual pitfalls are related to the NPV rather than the IRR. The paper affirms that: (i) if a project is conventional, the IRR being the NPV function root, is a rate of return or an interest rate and much better than any other modified IRR; (ii) irrelevant IRRs are due to an imperfection of the NPV method that should not be used for evaluating nonconventional projects; (iii) if a project is nonconventional the GNPV method should be used that is an extension of the NPV method from one to two different discount rates for investment and loan; (iv) the GIRR and GERR are rate of return and rate of cost for nonconventional project.
Keywords: Capital budgeting, pitfalls of the IRR method, multiple IRR, absence of IRR, irrelevant IRRs, imperfection of NPV, GNPV, GIRR, GERR, reinvestment assumption, variable opportunity cost of capital.
JEL Classification: G1, G23, G31, O16, O22
Suggested Citation: Suggested Citation