Defining a Reliable Multi-Period Project Rate of Return. An Alternative to IRR.

Abstract

In this paper, we lay out theoretical shortcomings of the IRR criteria that have largely dropped out of the finance literature. We discuss the problem of multiple IRRs and non-existent IRR under a new light. We also discuss the financial ambiguity that can arise when interpreting the IRR. Then, we describe two new rate of return metrics proposed by Magni (2010, 2013). These include the Book Average Internal Rate of Return (BAIRR) and the Economic Average Internal Rate of Return (EAIRR). These revised rate of return metrics rely on different assumptions about the pattern of changes to the value of an investment over its economic life. The result is a multi-period rate of return measure that is free of the limitations of the IRR and is consistent with net present value (NPV). The approach links NPV and the rate-of-return notion in an explicit and intuitive way, such that the NPV may be found as a product of the overall invested capital and the project’s expected rate of return (net of the cost of capital). Consequently, for those settings in which a rate of return measure is needed, the two metrics provide alternatives that can be used.