Application Analysis on Internal Rate of Return Rule for Investment Decision
The net present value (NPV) rule is not the only criterion available to evaluate a capital investment proposal. You may be familiar with the payback period, the internal rate of return, or another criterion. This paper examines and explains how to apply to the NPV rule: the internal rate of return (IRR) rule, the criteria used by a large sample of companies when making capital budgeting decisions, with the IRR rules being the most popular and the average accounting return and PI rules being the least popular. We analyze whether the internal rate of return (IRR) rule satisfy the conditions of a good investment decision rule. Recall that a good investment decision rule must take into account the timing of a project's expected cash flows and the project's risk. In addition, it should select projects that increase the market value of the firm's equity. In our analysis of the alternative rules, we identify a number of cases in which the methods lead to a decision that contradicts the NPV rule. We explain why these conflicts occur and why some firms still use some of these techniques to screen investment proposals. We use the projects to illustrate how the alternatives to the NPV rule are usually applied in making investment decisions and compare their performance with that of the NPV rule.