TECHNICAL NOTE—THE INTERNAL RATE OF RETURN (IRR) AS A FINANCIAL INDICATOR

Author: Miroslaw Hajdasinski

Source: The Engineering Economist, Volume 49, Number 2, April-June 2004 , pp. 185-197(13)

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Abstract:

In their recent paper Tang and Tang (2003, pp. 69–78) revive a longstanding controversy—net present value (NPV) versus internal rate of return (IRR)—by characterizing the NPV as an economic indicator and the IRR as a financial one. The paper implies that this distinction justifies ranking financial alternatives by ranking their IRRs. In the current article, it is argued that the direct IRR ranking does not necessarily provide the same evaluation environment—and therefore a fair comparison—for each alternative involved, and that the incremental ranking approach is needed to remedy this shortcoming. The article also points out that Tang and Tang's numerical examples of simple projects with one sign change in their cash flow patterns do not address the problem of multiple IRRs, which consequently renders Tang and Tang's ranking approach dysfunctional. It is demonstrated that the concept of a true rate of return, substituting for the non-performing IRR and applied in conjunction with the incremental approach, provides an adequate tool for ranking mutually exclusive projects or a project's technical or financial alternatives.

Document Type: Research article

DOI: http://dx.doi.org/10.1080/00137910490453437

Affiliations: 1: School of Engineering, Laurentian University, Sudbury, Ontario, Canada

Publication date: 2004-04-01