scholarly journals The internal rate of return (IRR): projections, benchmarks and pitfalls

2016 ◽  
Vol 34 (6) ◽  
pp. 664-669 ◽  
Author(s):  
Michael Patrick ◽  
Nick French
Keyword(s):  
Design Methodology ◽  
Capital Budgeting ◽  
Cash Flows ◽  
Rate Of Return ◽  
Internal Rate Of Return ◽  
Content Type ◽  
Principal Measure ◽  
Internal Rate ◽  
Measure Of Performance ◽  
Practical Implications

Purpose The purpose of this paper is to discuss the use of the internal rate of return (IRR) as a principal measure of performance of investments and to highlight some of the weaknesses of the IRR in evaluating investments in this way. Design/methodology/approach This Education Briefing is an overview of the limitations of the IRR in making capital budgeting decisions. It is illustrated with a number of counter-intuitive examples. Findings The advantage of the IRR is that it is, on the surface, a wonderfully simple benchmark. One figure that tells a story. But, the disadvantage is that if used in isolation the IRR can give misleading results when used to assess investment proposals. Practical implications The IRR should be used in conjunction with other analyses to appraise projects, so that the user can determine its veracity in the context of other benchmarks. This context is particularly important when assessing investments with unusual cash flows. Originality/value This is a review of existing models.

scholarly journals Reinvestment Bias When Analyzing Mutually Exclusive Assets

2011 ◽  
Vol 2 (3) ◽  
pp. 71
Author(s):  
Robert J. Sweeney
Keyword(s):  
Net Present Value ◽  
Capital Budgeting ◽  
Cash Flows ◽  
Rate Of Return ◽  
Internal Rate Of Return ◽  
Present Value ◽  
Internal Rate ◽  
Current Period ◽  
The Cost ◽  
Flows Over Time

Capital budgeting decisions generally involve the commitment of resources in the current period to secure positive cash flows over time that generate a rate of return in excess of the cost of the funds invested. The most common techniques used to perform this analysis are the Net Present Value (NPV) and the Internal Rate of Return (IRR).Conceptually, these two techniques are substitutable; i.e. the resulting decision from a NPV analysis is identical to the decision from an IRR analysis. In practice, however, the NPV and the IRR can, on occasion, produce conflicting decisions. Specifically, when analyzing mutually exclusive assets the Net Present Value can support one asset while the Internal Rate of Return supports the other. The purpose of this paper is twofold; first, to highlight structural deficiencies in the conventional application of the NPV and the IRR, and second, to demonstrate a procedure to correct for these structural errors.

scholarly journals Mutually exclusive capital projects: A critique of Fisherian analysis

1994 ◽  
Vol 25 (1) ◽  
pp. 47-51
Author(s):  
S. Paulo
Keyword(s):  
Net Present Value ◽  
Capital Budgeting ◽  
Cash Flows ◽  
Rate Of Return ◽  
Internal Rate Of Return ◽  
Present Value ◽  
Rates Of Return ◽  
Capital Projects ◽  
Internal Rate ◽  
Project Life

In capital budgeting a Fisherian analysis is undertaken to resolve conflicts in rankings which arise when mutually exclusive projects have been evaluated according to the net present value and internal rate of return criteria. Within the literature, the projects which have been subjected to a Fisherian analysis, all have the same required rates of return because the required rate of return is held constant irrespective of the differences in the characteristics of the mutually exclusive projects. The conflict in rankings of mutually exclusive projects is typically ascribed to characteristics such as differences in initial outlay and project life span, disparities in the timing of cash flows, the reinvestment rate assumption, and the difficulties of multiple or no unique internal rate of return when the cash flows are non-conventional. Despite these differences among projects, the same required rate of return is used. The central question which is addressed in this article, is whether the same required rate of return can reasonably be used for the valuation of each of the mutually exclusive projects, as well as when a choice is made from among the mutually exclusive projects. In the discussion this 'conventional wisdom' of a constant required rate of return for both the valuations and the choice of an alternative is questioned, and it is suggested that one of the causes of a conflict in rankings may be the use of incorrectly specified required rates of return. Also presented in this article is a conceptual framework which enables a modified Fisherian analysis.

Capital budgeting decision-making practices: evidence from Pakistan

2019 ◽  
Vol 16 (2) ◽  
pp. 142-167
Author(s):  
Afeera Mubashar ◽  
Yasir Bin Tariq
Keyword(s):  
Risk Assessment ◽  
Real Options ◽  
Weighted Average ◽  
Capital Budgeting ◽  
Equity Capital ◽  
Rate Of Return ◽  
Internal Rate Of Return ◽  
Content Type ◽  
Listed Firms ◽  
Internal Rate

Purpose The purpose of this paper is to examine the current trends of capital budgeting practices (analysis techniques, discount rate estimations and risk assessment methods) among Pakistani listed firms and analyze the responses conditional on firms’ demographics and executive characteristics. Design/methodology/approach An online questionnaire was sent via e-mail to top 200 non-financial firms (in terms of market capitalization) listed on Pakistan Stock Exchange. Findings With a response rate of 35 percent, it is concluded that the theory–practice gap is low as Pakistani listed firms are using discounted cash flow methods of capital budgeting and preferring net present value over internal rate of return. Similarly, weighted average cost of capital is estimated using target value weights, and capital asset pricing model (with extra risk factors) is used to determine the cost of equity capital. For risk assessment, sensitivity analysis and scenario analysis are the dominant approaches; however despite the theoretical superiority, the use of real options is very low. Overall, investment decision responses significantly differ across firm’s demographics and executive characteristics. Practical implications Pakistani business schools need to address the low usage of advanced methods such as modified internal rate of return and real options among Pakistani listed firms. Originality/value This is the first comprehensive study on the topic in Pakistan and have highlighted the areas of capital budgeting where Pakistani firms’ practices deviates from finance theory.

scholarly journals Capital budgeting practices in South Africa: A review

2012 ◽  
Vol 43 (2) ◽  
pp. 11-29 ◽  
Author(s):  
C. Correia
Keyword(s):  
South Africa ◽  
Cash Flow ◽  
Net Present Value ◽  
Financial Analysis ◽  
Capital Budgeting ◽  
Cash Flows ◽  
Rate Of Return ◽  
Internal Rate Of Return ◽  
Significant Growth ◽  
Internal Rate

This paper reviews the capital budgeting survey literature in South Africa over the period 1972 to 2008. The survey evidence indicates a significant growth in Discounted Cash Flow (DCF) methods and a fall in the use of other methods. In particular, there has been growth in the use of Net Present Value (NPV). Yet, the Internal Rate of Return (IRR) technique remains the primary method used in practice despite some serious drawbacks. Larger companies are more likely to use DCF methods. There has been a significant growth in the use of sensitivity analysis and scenario analysis. However, there is little use of sophisticated risk analysis tools such as Monte Carlo simulation, and decision trees. Although financial theory predicates the use of risk adjusted discount rates, surveys indicate that the majority of companies use a single firm discount rate. Companies have increasingly used inflation-adjusted cash flows but the process of ranking mutually exclusive projects is not aligned with finance theory. There is limited use of the Modified Internal Rate of Return (MIRR) method and DCF dominant companies do not outperform non-DCF dominant companies. The most important phase of project evaluation is the project definition and cash flow estimation phase and yet research studies have focused mainly on the financial analysis and project selection phase.

scholarly journals Evaluation of Investment Projects: A Case from Turkish Cement Sector

2016 ◽  
Author(s):  
Miyase Karabulut ◽  
Sıtkı Sönmezer ◽  
Vedat Zeki Yenen ◽  
Zeynep Emir
Keyword(s):  
Qualitative Research ◽  
Net Present Value ◽  
Capital Budgeting ◽  
Rate Of Return ◽  
Internal Rate Of Return ◽  
Present Value ◽  
Investment Projects ◽  
Preliminary Results ◽  
Internal Rate ◽  
Exclusive Or

Capital budgeting is crucial for firms that have projects to evaluate especially when the projects are mutually exclusive or financing is scarce. The aim of the study is to determining the most widely used methodologies in capital budgeting decisions and their effectiveness. A qualitative research will provide cement sector specific examples in assessing industry projects and compares the methods of Net Present Value, İnternal rate of Return, Pay-back period, discounted pay-back period and MIRR. Each method is briefly discussed and its drawbacks and advantages are mentioned in detail. Other sectors are also examined in terms of capital budgeting. Our preliminary results indicate that net present value method dominates capital budgeting decisions in the sectors under study.

scholarly journals Use of Probabilistic Cash Flows in Analyzing Investments Under Conditions of Risk and Uncertainty

1976 ◽  
Vol 8 (2) ◽  
pp. 19-24 ◽  
Author(s):  
James W. Richardson ◽  
Harry P. Mapp
Keyword(s):  
Net Present Value ◽  
Average Rate ◽  
Capital Budgeting ◽  
Cash Flows ◽  
Rate Of Return ◽  
Internal Rate Of Return ◽  
Risk And Uncertainty ◽  
Small Farm ◽  
Perfect Knowledge ◽  
Net Returns

Managers of business firms, large or small, farm or nonfarm, must make investment decisions under conditions of risk and uncertainty. However, in evaluating investments, the assumption of perfect knowledge has often been used to simplify the analysis. For example, an estimate of average annual net returns is frequently discounted into perpetuity to evaluate a real estate investment alternative. Capital budgeting literature suggests a number of approaches to evaluating alternative investments. However, use of concepts such as the payback period, average rate of return, internal rate of return and net present value embodies the assumption of perfect knowledge.

Financial impact of high land prices on the viability of winery startup projects

2021 ◽  
Vol ahead-of-print (ahead-of-print) ◽  
Author(s):  
Michael Santos ◽  
Vincent Richman ◽  
Aidong Hu
Keyword(s):  
Net Present Value ◽  
Weighted Average ◽  
Capital Budgeting ◽  
Investment Horizon ◽  
Internal Rate Of Return ◽  
Content Type ◽  
Land Prices ◽  
Practical Implications

Purpose Does it make economic sense to invest in winery startups with high land prices? This paper aims to apply a capital budgeting analysis for a startup project to investigate the role of land prices in the decision-making of a wine entrepreneur. Design/methodology/approach This paper uses a capital budgeting analysis to evaluate the value of a winery project using the six investment criteria: net present value (NPV), internal rate of return (IRR), modified IRR, profitability index, payback period (PB) and discounted PB. Findings This study finds that high land prices are economically justifiable (NPV is greater or equal to zero) when the weighted average capital cost is sufficiently low for investors who are able to diversify risks and with access to a cheap source of funds. Additionally, this study demonstrates that wine entrepreneurs need a long-term investment horizon because the recovery of the initial investment in winery startup projects takes many years. Research limitations/implications The startup winery projects are heavily influenced by wine pricing, production and cost assumptions. As a result, different assumptions made at other wine regions may result in slightly different outcomes for the acceptability of the wine startup projects. Practical implications High land prices are economically justified for investors and entrepreneurs with the ability to diversify risk and access to cheap financial resources. As such, land prices can be a critical obstacle for individual entrepreneurs who experience a lack of capital. Social implications In the famous wine regions of the world, high land prices may result in more wineries being owned by the capital rich wine conglomerates. Originality/value This paper provides estimations of land prices based on financial methods to discuss the justification of observed prices and the implications regarding the ability of investors and entrepreneurs to access capital.

Property investment: gearing and the equity rate of return

2019 ◽  
Vol 37 (3) ◽  
pp. 323-328 ◽  
Author(s):  
Nick French
Keyword(s):  
Design Methodology ◽  
Investment Project ◽  
Equity Returns ◽  
Rate Of Return ◽  
Content Type ◽  
Bank Rate ◽  
Increased Risk ◽  
Practical Implications ◽  
Different Levels

Purpose The purpose of this paper is to comment upon the relatively straightforward but often misunderstood role of gearing (or leverage) on the potential equity return of a property investment. Design/methodology/approach This education briefing is an explanation of the upside and downside risk of borrowing (at different levels) to successful investment. Findings The use of gearing can greatly enhance equity returns but at an increased risk. Practical implications The process of borrowing at a bank rate below the return rate on an investment project can increase the equity return of the project as long as all incomes and discount rate remain at appropriate levels. Originality/value This is a review of existing models.

“The lost decade”: an MPT perspective

2015 ◽  
Vol 41 (11) ◽  
pp. 1202-1220 ◽  
Author(s):  
Anthony Loviscek
Keyword(s):  
Design Methodology ◽  
Annual Rate ◽  
Rate Of Return ◽  
Average Risk ◽  
Monthly Data ◽  
Content Type ◽  
Core Set ◽  
Out Of Sample ◽  
Lost Decade ◽  
Practical Implications

Purpose – The purpose of this paper is to test the efficacy of an application of modern portfolio theory (MPT) from 2000 through 2009, a period during which the annual rate of return on the S & P 500 is negative. The financial media have called this period “the lost decade” for investors. Design/methodology/approach – Using monthly data, the author uses a series of annual out-of-sample tests to compare the risk-reward performances of MPT portfolios against those of the S & P 500. Findings – The author finds that the MPT portfolios outperformed the S & P 500. During the “lost decade”. They generated a cumulative return of over 77 percent compared to a cumulative return of −9.1 percent on the S & P 500. Moreover, the MPT portfolio β’s are low, ranging from 0.45 to 1.01, suggesting above-average risk-reward performances. Research limitations/implications – The MPT portfolios are relatively small, and might not be well diversified. That said, they comprise a core set of securities that could help investors achieve a risk-reward performance that exceeds that of the S & P 500. Practical implications – The results suggest that investors should not overlook the potential of MPT, despite its theoretical and practical limitations, to provide above-average returns at below-average risks. Originality/value – This is the first study to show the efficacy of MPT during a period in which it was criticized at having failed investors when they needed it most.

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