The overall rate of return as a profit measure for capital projects

Abstract

The internal rate of return (IRR) is often used by industrial corporations as the profit measure for evaluating the acceptability and/or ranking of capital projects. This practice is so prevalent that its validity is seldom questioned; the only complaint appears to be that the calculation of the IRR is cumbersome. In reality, the IRR is not generally a reliable profit measure, and many arguments in favor of its use are not valid [1]. On the other hand, the net present value (NPV) of the cash flow of a project, when discounted at the appropriate hurdle rate, is recognized as the most reliable profit measure for evaluating and ranking capital projects. However, some corporate executives have a disdain for the use of NPV because the concept is not an intuitively obvious indicator of the magnitude of the profit. While NPV should still be used as a decision criterion in economic evaluation of capital projects by analysts, a more useful and persuasive profit measure for presentation to top management appears to be the overall rate of return (ORR).