A CRITIQUE OF A CAPITAL PROJECT

APPRAISAL TECHNIQUES
Simon M Keane

CONTENTS
3.1 Introduction
3.2 Underinvestment bias in conventional capital budgeting techniques
3.3 Wealth creation versus wealth accretion
3.4 Nonrationing versus Rationing
3.5 Does the NPV method need support?
3.5.1 Payback
3.5.2 Internal Rate of Return
3.5.3 The significance of Scale
3.6 Investment fallacies
3.6.1 The positive-NPV fallacy
3.6.2 The reinvestment fallacy
3.6.3 Investment efficiency fallacy.
3.7 Does IRR have any role?
3.7.1 Can IRR ever serve as an alternative to NPV in ranking projects?
3.7.2 Can IRR serve as a supplement to NPV?
3.7.3 Is IRR equal to NPV as an accept-or- reject criterion?
3.7.4 Is IRR useful in rationing conditions?
3.7.5 Is IRR a useful aid to nonfinancial managers?
3.7.6 Can IRR serve even as a preliminary screening method?
3.7.7 Is IRR not a better link to the rate of return in subsequent financial reporting?
3.8 Why is the yield approach acceptable in the securities market but not in the
product market?
3.9 Conclusion
3.10 Summary

Tutorial questions
Problems
Suggested further reading
3.1 INTRODUCTION

Most Finance text books agree that the Net Present Value (NPV)
method is the optimal investment selection criterion, but they also tend to
suggest that the Internal Rate of Return (IRR) has a significant role to play,
and to a lesser extent the Profitability Index (PI) and even Payback (PB).
The argument is often made that investment decisions are too important to
be left to a single method of appraisal. Decision-makers need to see the
problem from more than one, and possibly several, perspectives. This multi-
criteria approach to capital budgeting is widely reflected in practice, in that
most large companies use several methods to make investment decisions,
except that IRR tends often to be preferred over NPV as the appropriate
Discounted Cash Flow method. The purpose of this chapter is to review
this multi-criteria approach and to show that:

A) The IRR method is fundamentally flawed as an investment

appraisal method and, like Payback and PI, has no defensible role
in capital budgeting decisions,

B) The use of the above measures, together with the popular

interpretation of the Positive NPV rule, have a propensity to
encourage underinvestment,

C) The widespread practice of using two or more methods for

investment appraisal purposes is more likely to confound rather
than enrich the decision process. The NPV method should be used
as the sole criterion under all conditions, being the only method
consistent with the primary financial objective of the firm.

3.2 UNDERINVESTMENT BIAS IN CONVENTIONAL CAPITAL

BUDGETING TECHNIQUES
 The chapter adopts the corporate objectives developed in Chapter 2
where it was shown that the appropriate goal is “to maximise the value of
the firm subject to maximising the share price” (MAX VtMAX Pt). This
translates to a capital budgeting context as “to maximise the present value of
the firm’s investments subject to maximising their net present value” (MAX
PVtMAX NPVt ).

To develop the argument we first need to show why there is an

underinvestment bias in standard investment selection criteria, in particular
a propensity for conventional capital budgeting decision rules to be
influenced by the logic of capital rationing even when nonrationing
conditions are explicitly assumed to hold.

Symptomatic of this bias are three widely held misconceptions that

will be later discussed in some detail. These are the assumption i) that, for
a project to be acceptable, it must in practice have a positive, as
distinct from a nonnegative, net present value (the "positive-NPV
fallacy") ii) that the reinvestment opportunities for a project's
intermediate and terminal cash flows are relevant to the project's degree of
acceptability, (the "reinvestment fallacy") and iii) that a project is
more desirable the more efficient its use of capital, in the sense that, for a
given NPV, a quick payback is preferred to a slow payback, and a
high IRR or Profitability Index preferred to a low one (the "investment
efficiency fallacy").

To illustrate these fallacies consider the two mutually exclusive

projects, A1 and A2, in Table 1 available to a company operating in
normal, nonrationing conditions. It is assumed that neither project will be
replaced on completion. The projects have identical positive NPVs and
both are obviously acceptable. Conventional theory would suggest that
they are equally attractive or, possibly, that the project with the lower
outlay and shorter life should be favoured. To test the intuitive appeal of
this interpretation, the above problem was presented to a group of students
who had successfully completed a standard introductory course in
Business Finance. 92% of the students indicated either that A1 is less
attractive than A2 or that, at best, the two are equally desirable. The main
reasons given for favouring A2 were that the investment capital "saved"
might be better employed in other projects, and that A2 is more desirable
because it employs less capital to generate the same amount of NPV.
 This reasoning illustrates all three of the above misconceptions.
First, the preference for A2 over A1 implicitly negates the desirability of
zero-NPV investment, given that A1 is equivalent to A2 plus a zero-NPV
investment of 8M. Even the more orthodox view that the choice is a matter
of indifference indicates a failure to acknowledge the positive worth of
the incremental investment of £8M. Secondly, it implies that the extra
capital invested in A1 might be better employed in financing additional
projects, thus failing to recognise that such additional projects could equally
be financed from an issue of new capital and undertaken in conjunction with
A1. Thirdly, it implies that, for a given NPV, a project is more desirable
the more "efficient" it is, by having, for example, a higher profitability
index or a shorter payback. It will be shown in this chapter that these
considerations have no bearing on the respective attractiveness of the two
competing projects under normal, nonrationing conditions. It will also be
argued that, unless project A1 is instinctively perceived to be more desirable
in a nonrationing environment, an underinvestment bias can be assumed to
exist. It will subsequently be shown that the ultimate source of this bias is a
failure of traditional investment theory to recognise the effects of scale.

3.3 WEALTH CREATION VERSUS WEALTH ACCRETION

Before proceeding it is necessary to define some relevant terms.

"Market criterion" denotes the fundamental requirement that a project
should earn no less than the minimum acceptable rate of return for the level
of risk, or, equivalently, that it should be expected to have a nonnegative
impact on the share price. The term "wealth creation" is used to denote the
process of transforming investible funds into productive investments
that satisfy the market criterion (the zero-NPV component of an investment).
The term "wealth accretion" is used to denote a project's positive-NPV
component, if any. Hence a zero-NPV project consists only of the
primary wealth creation process, whilst a positive-NPV project contains
both the wealth creation and wealth-accretion components. This distinction
is important because a key assumption here is that "wealth creation" is not
only desirable, but may in practice be the principal activity of many
seasoned companies in mature industries. Wealth accretion, it will be
argued, is a desirable adjunct but should not be seen as a pre-condition of
investment.
3.4 NONRATIONING VERSUS RATIONING

A further distinction that needs to be made is between rationing and

nonrationing conditions. Students often assume that capital rationing is
the normal state for companies. Most firms, it is assumed, have a limited
amount of capital available to them to undertake new projects. But when we
consider what capital rationing means we have to conclude that it is in fact
an irrational state that should rarely, if ever, exist for a listed company.

It is true that intuitively it is appealing to assume that most companies

probably face a shortage of capital and could undertake more investments if
they could only find the finance. The significance of being listed on the
stock market, however, is that a company acquires access to the capital
needed to finance any project that satisfies the market criterion. The
implication of a project with a nonnegative NPV is that it is expected to
satisfy the cost of capital criterion. It is, therefore, a contradiction in terms
for a company to face capital rationing. The company cannot rationally
argue that it is unable to finance a specific project that meets the market
criterion since the NPV is measured by discounting the cash flows at the cost
of raising the necessary capital. If a company discounts its projects at a
particular discount rate and then claims that it cannot find the funds to
finance the project then it is clear that the discount rate is understated. It
should raise the discount rate to the level at which it can raise capital.
Capital is rationed not be quantity but by price. If the NPV calculation
reflects this price then it follows that the normal condition for listed
companies is one of nonrationing. Companies, in effect, face a limited
number of acceptable projects rather than a shortage of capital to finance
them.

3.5 DOES THE NPV METHOD NEED SUPPORT?

The central issue addressed in this chapter is whether NPV should be the
sole criterion or is more effective if supported by other selection criteria.
The following analysis will focus on the IRR because it has the strongest
claim to be treated as an alternative to NPV. Payback, however, is still the
most widely used technique and deserves some comment.
3.5.1 PAYBACK

The textbooks base their criticism of Payback on the fact that it

ignores a) the cash flows after the payback period and b) the time value of
money. The underlying assumption, therefore, is that, were it not for these
defects, the principle of seeking an early payback is fundamentally sound.
But if we accept the premise that all investment is desirable provided it
satisfies the present value acceptance criterion then it becomes clear that an
early payback is not in itself desirable. It is often defended as indicating the
risk and the liquidity implications of the project. Apart from the fact that it
is wholly inadequate measure of risk or liquidity it is essential to recognise
that the object of investment is not to minimise either risk or illiquidity. The
essence of investment is to assume risk and to part with liquid funds. The
object is to earn a return that compensates for the risk and commitment of
funds, and Payback does not even pretend to measure return. It is, in effect,
an anti-investment measure, the logic of which is that the optimal investment
is to keep all cash in the bank. It is important to recognise that, for a given
NPV, the longer the payback period the better. If it is agreed that acceptable
investment is good then it is better that a project lasts two years than one
year, and so forth.

For example, the most common assumption is that investment A3 in

Table 1 is preferable to investment A4 because it generates the same NPV in
two years instead of six. But investment A4 is equivalent to investment A3
plus an additional 4-year investment of £5M with a zero NPV. Now since by
definition a zero NPV investment earns the minimum acceptable return, then
it is desirable and should be undertaken. The argument that A4 releases
capital for reinvestment is fallacious because, if a further investment
presents itself, the company can raise the necessary capital and undertake it
in conjunction with investment A3. To argue otherwise is to suggest that the
company is operating under capital rationing. The weakness with PB,
therefore, is not that it ignores the time value of money but that it is based on
the misconception that long-term investment is intrinsically bad. If we
accept that investment is good provided it satisfies the market criterion,
other things being equal, then the longer an investment lasts the better.
Payback is irrelevant and misleading.

3.5.2 INTERNAL RATE OF RETURN

IRR answers the question “ what is the maximum cost of capital the
project can bear?” The issue is, can this statistic ever replace or reinforce
the net present value?

The traditional arguments in favour of IRR are:

1. That businessmen think in percentage terms, and

2. It does not require a precise calculation of the cost of capital

The first argument is irrelevant if it can be shown that IRR is

fundamentally invalid, and the second argument is a fallacy because,
although IRR can be calculated without knowing the cost of capital, it
cannot be used without it since the cost of capital is the benchmark for
deciding whether the project is acceptable.

Traditional arguments against IRR:

1. IRR assumes reinvestment at a rate equal to the IRR.

2. Some projects have more than one IRR

In this chapter we will show why the case against IRR cannot validly be
made on the basis of either of these arguments and is flawed for a more
fundamental reason than either.

The generally held view is that IRR is inferior to NPV but useful for
comparing projects unless the projects a) have unequal lives b) have unequal
outlays or c) have significantly different cash flow patterns. In effect, this
view states that, to be confident that IRR is valid in comparing two or more
projects, the projects must be virtually identical. If they are not identical
there is no way of being sure that IRR gives the correct ranking without
reference to the projects’ NPVs.

3.5.3 THE SIGNIFICANCE OF SCALE

The key factor in explaining the fundamental weakness in IRR is the

issue of investment scale. Commonsense suggests that a relative measure
of worth such as IRR is inappropriate when comparing projects of different
scale. A project costing £1,000 may have an IRR of 40% but this is
immaterial when compared to a competing project costing £20M with an
IRR of 30% (assuming both have the same cost of capital, say 15%). The
only thing that matters is the respective NPVs of the projects. Although
most textbooks recognise the effect of a size difference in judging the
relevance of IRR, they fail to recognise that size is not simply a function of
initial investment but of both the length of period over which the investment
lasts and the pattern of the cash inflows over the project’s life.

Consider the projects in Table 2. The conventional explanation for

the different rankings given by IRR and NPV for projects B1 and B2 is the
difference in cash flow patterns, and for projects B1 and B3, the difference
in lives, and for projects B1and B4, the difference in size. But these
differences are all symptoms of the same phenomenon, the scale effect.
Equating the size of a project with its initial outlay, without taking account
of the duration or pattern of the cash flows, is analogous to equating the
size of a building with the area of land it occupies without taking account
of the height of the structure or the configuration of its architecture. The
outlay reflects the initial allocation of capital to the project but it does not
capture the scale of the capital invested throughout the project's life.

To derive a common measure which fully reflects the three

dimensions of scale - outlay, cash flow pattern and life - the equivalent
investment of capital over a single year can be calculated, as in Table 3.
Continuing the previous analogy, this measure is comparable to the
aggregate square footage of a building, which clearly better reflects the
scale of the building than the area of land it occupies. Applying the same
measurement technique to the other projects, this reveals that project B1 in
Table 2 is significantly greater in scale than any others. Even B4 is greater
than B2 or B3, despite the lower outlay. It has a lower return than B3 but a
higher NPV as a result of being significantly greater in scale.

The Equivalent Capital Investment over a single year may have

little practical significance,1 but it demonstrates the central principle that
every project has a unique scale. Whatever the outlays, cash flow
patterns, or lives of the projects, conflicts between IRR and NPV can be
attributed wholly to differences in scale. Not only are reinvestment
opportunities for the intermediate cash flows irrelevant in interpreting the
two methods, but there is no need to seek an alternative explanation for any
conflict between them.
 The effect of conventionally treating these three dimensions of
scale as distinct phenomena is that, when conflict between IRR and NPV
happens not to arise, IRR tends to be interpreted as valid. But the absence of
conflict does not validate the use of a relative measure in circumstances
where it is inherently wrong. The issue of scale is present even when its
effect does not manifest itself in a conflict the two measures. This is
evidenced by the fact that it is never possible to be certain that conflict is
absent except by first estimating the respective NPVs of the projects. If the
NPV is not calculated, the IRR can be used with confidence to rank projects
only when the projects are substantially identical.

It may appear an academic nicety to argue that, even when a method

gives a correct ranking, it remains incorrect in principle. The point is
stressed, however, for two reasons. First, if a company uses IRR when it
accords with NPV, and then, at a later date, avoids the method when it
clashes with NPV, it will cause unnecessary confusion for the method to
have been declared "valid" in the one set of circumstances and invalid in the
other. Second and more fundamentally, even when IRR happens to accord
with NPV, it gives a misleading signal about the project's degree of
desirability. The significance of this effect will be examined shortly. It is
sufficient at present to note that one project is never superior to another by
virtue of simply of having a higher IRR. If it happens to have both a higher
NPV and IRR this is coincidental, and indicates simply that the differences
in scale happen to be insufficient for the fundamental flaw of IRR to
manifest itself.

In summary, the fact that all capital projects are different in scale
implies that an absolute measure of added value is the only relevant
criterion of project worth. IRR as a ratio is fundamentally unsuited for
comparing competing projects. In effect, provided a project's return meets
the minimum required rate for the risk class, the project’s degree of
"profitability" is irrelevant, only its contribution to value.

3.6 INVESTMENT FALLACIES

It is now possible to put in perspective the three fallacies identified at

the beginning of the chapter.

3.6.1 THE POSITIVE-NPV FALLACY

 The primary fallacy consists of assuming that, because some positive
NPV projects are available, a project must have a positive NPV to be
desirable. This would imply that a project must be more than acceptable to
be desirable. Some texts are quite explicit about this:

"Financial managers should only accept those actions which are

expected to increase the share price" (Gitman, 1991, p18)

A greater NPV is, of course, always preferable to a lesser one, but

the only precondition of investment is that the project should have a
nonnegative price reaction, this being the visible manifestation of the
nonnegative-NPV rule. The primary object therefore is to create wealth not
to achieve wealth accretions, in effect not to maximise NPV but to
maximise long-term PV subject to maximising NPV. A positive NPV is a
bonus not a precondition of investment. Indeed, if it is contended that it is
a pre-condition, it is a short step to assuming that the magnitude of the
positive NPV should be significant, with the result that it is the Profitability
Index that becomes the criterion of acceptance rather than NPV, leading to
the possibility that the firm may reject some positive-NPV projects.

It follows that, even in a world where the opportunity to

generate wealth accretion exists, the conventional goal of share price
maximisation fails to represent the primary role of investment. The
alternative goal of maximising the value of the firm subject to maximising
the share price (MAX VtMAX Pt) implies that, although every opportunity
to increase the share price should be taken, the expectation of a rise is not a
prerequisite of investment. The significance of the share price constraint is
that projects should not be undertaken which are expected to reduce the
price. Only in a grossly uncompetitive world where there is a universal
excess of positive-NPV projects is it possible to make wealth accretion the
exclusive goal of business.

3.6.2 THE REINVESTMENT FALLACY

The overemphasis on achieving excess returns has led in turn to the

assumption that the possibility of using a project's cash flows to finance
additional excess-return opportunities is relevant to its perceived worth.
Underlying the reinvestment fallacy, therefore, is the assumption that the
discounting process penalises later cash flows more severely because early
cash flows are available for reinvestment. Early flows, however, are
rewarded in the discounting process not because they make possible new
investment but because they give the option of paying off the capital used to
finance the original investment. This is why we discount at the cost of
capital. It is irrelevant whether the firm actually uses the cash to repay the
capital or chooses to use it to finance new investments, however profitable
these might be. In a nonrationing environment, it is a matter of indifference
whether the firm uses cash inflows from an old investment or new capital to
finance its new investments, since the necessary capital can readily be raised
at the appropriate market rate.2 For example, even if the £11M cash inflow
in period 1 of project C2 in Table 4 could be reinvested in a new project C3
with a positive NPV of £5M, C1 would remain the more desirable of the
two because C3 could be financed independently at 10% and undertaken
in conjunction with C1. A project, therefore, is not more desirable for
releasing capital earlier rather than later, except under capital rationing.

The classic manifestation of the fallacy is, of course, in the IRR

versus NPV debate. Thus, the conventional criticism of the Internal Rate
of Return is that it assumes reinvestment at a rate equal to IRR. Although
this issue has been identified in the literature (Dudley 1972, and Keane
1979), the misconception about the relevance of reinvestment opportunities
has persisted, and seems to have become entrenched in the investment
literature. The criticism of IRR is specious because it is meaningless to
impute to IRR such an assumption, since, as already noted, the destiny of
the cash flows is irrelevant except under rationing conditions. Hence, the
fundamental flaw in IRR has nothing to do with assumptions about
reinvestment opportunities for the intermediate cash flows but can be
explained wholly by the effects of scale. Applying the scale-measurement
technique illustrated in Table 3, it can be shown that all investments are
different in scale, whatever their initial outlay. Therefore, IRR, as a ratio, is
fundamentally irrelevant for comparing investments, even when the
outlay is the same. If IRR happens to accord with NPV in ranking
particular projects this is pure chance. The technique is wrong in principle
for comparing capital projects.

3.6.3 INVESTMENT EFFICIENCY FALLACY.

A natural extension of the assumption that early recovery of cash is

intrinsically desirable is the belief that a project is more desirable if it is
efficient in the use of capital. This belief is evidenced by the near
universal practice by companies of using efficiency criteria such as IRR
and PB to support the NPV method, (Indeed the evidence indicates that
about 70% of smaller companies exclusively use one or more of the
standard efficiency measures in preference to the absolute NPV method
(Runyon 1983).

It is clear, however, that, provided an investment satisfies the market

criterion, its degree of efficiency is irrelevant. Indeed, in the sense that
investment efficiency is conventionally understood, the less efficient a
project is in generating a given (nonnegative) NPV the more desirable it
is. Hence, if a project is acceptable, a slow payback has the merit that it
prolongs the wealth-creation process. The notion that early cash recovery is
not intrinsically desirable may seem at variance with ordinary business
liquidity considerations, but, in nonrationing conditions, the discounting
process should fully reflect the liquidity implications of an investment. To
discount each project's cash flows at the acceptable rate of return, and then
mentally to penalise some projects for being less efficient than others in
their use of capital, is double counting for cost-of-capital effects. It is not
simply that efficiency indicators fail to support the NPV method. They
positively militate against the primary wealth-creation process. Given the
premise that the object of investment is to create wealth and, wherever
possible, to generate wealth accretions, the only relevant measures are
those that signal absolute wealth effects.

For example, consider the projects in Table 5. The basic NPV rule
favours D2 over D1 and D3, but there is a risk that the tendency to attach
significance to investment efficiency might lead some decision-makers to
prefer D1. D2, of course, is preferable, both because of its higher NPV
and its greater scale. But D3 is preferable to both because it is the most
consistent with the MAX VtMAX Pt and MAX PVtMAX NPVt rules
established in the objectives chapter. Most decision-makers versed in
conventional capital budgeting criteria would probably favour D2 over D3,
but D3 puts to use £500M of capital and still satisfies the market criterion.
In effect we are conditioned to perceiving an “efficient” return per pound
invested as important, but the efficiency of a project is in fact irrelevant
provided it meets the MAX PVtMAX NPVt criterion.3
3.7 DOES IRR HAVE ANY ROLE?
It is now possible to consider whether IRR has any valid role in capital
budgeting. The focus is on IRR rather than the alternative competitors for
NPV because it is the most popular DCF method in practice and the measure
with the best claim to provide to have a valid status. The arguments that
follow, of course, apply even more forcefully to Payback.

For the purposes of the discussion that follows it is useful to

distinguish between “investment selection methods” and “investment
decision tools”. The case against using IRR, PI and Payback as investment
selection criteria does not imply that the numbers represented by IRR, PI
and PB should never be used by the financial manager. An investment
selection method provides the benchmark for acceptance or rejection of
a project, whether primary or secondary. For example, a company might
employ each of NPV, IRR, and Payback as investment methods, without
even stating which is the primary method. Or it might use Payback as a
preliminary screening method. An investment decision tool, on the other
hand, is a statistic or device that might be used in applying a given
investment method in a particular set of circumstances. For example, the
Profitability Index may be useful under capital rationing conditions to
help identify the combination of projects that maximises NPV, without PI
having the status of a separate selection method.

In assessing the desirability of a multiple-criteria approach, therefore,

we are concerned with the practice of employing multiple investment
methods rather than multiple investment decision tools. The latter statistics
may be important elements in deriving the former but they are not
themselves the criteria by which investment worth is judged

In order to decide whether IRR has any role in investment appraisal it is

necessary to consider the full range of potential uses, from a stand-alone
measure of investment worth to a simple aid to nonfinancial managers.

3.7.1 CAN IRR EVER SERVE AS AN ALTERNATIVE TO

NPV IN RANKING PROJECTS?
 We have argued that IRR can never be viewed as a valid alternative to
NPV in ranking projects because of the scale effect. Projects always come in
parcels and the rate of return per pound invested can never be an alternative
to the absolute measure of added value.

INCREMENTAL APPROACH

Textbooks often suggest that the scale problem of IRR can be partially
overcome by using an incremental approach where the cash flows of smaller
project are subtracted from those of a larger project so that the incremental
cash flows can be evaluated as a simple accept-or-reject decision.

The use of this approach, however, is severely limited:

a) the projects must have identical risk otherwise it is like deducting

apples from oranges, since the quality of the respective cash flows
is different.
b) they have must identical outlays, otherwise the incremental IRR
relates to year 1 or later when the cash flows first differ. It is
difficult to conceptualise the significance of an IRR relating to
cash flows commencing in the year ahead.
c) there is a significant chance that subtracting the cash flows of one
project from those of another will give rise to more than one sign
change and therefore to the multiple yield problem.
d) the approach is clumsy if there are several projects since each has
to compared incrementally with all the others.
e) more significantly, even if the above restrictions are met, the
resulting measure gives no information that the NPV would not
give, and indeed less since it fails to indicate the incremental value
of the respective projects.

The aim of the incremental approach is to convert a ranking of

projects into an accept-or-reject decision by comparing the incremental cash
flows of two or more projects. It will be shown later that this objective is of
dubious value since, even in an accept-or-reject context, the IRR is
misleading. Not only is the incremental approach an unsuccessful technique
for the purposes of salvaging IRR but it will be argued that the attempt to
salvage IRR is itself a fruitless endeavour.

3.7.2 CAN IRR SERVE AS A SUPPLEMENT TO NPV?

 The most common defence for IRR is that, as a secondary measure, it
provides additional insights that act as a useful supplement to NPV. The
investment decision is too important, the argument goes, to be left to a single
criterion, and IRR has the most convincing claim to provide support. The
NPV of a project may be a sufficient benchmark in principle, but in
practice the method is only as good as the input data, and it might seem
less risky to use supplementary measures even if they are theoretically
flawed. However, although the problems of measuring NPV are real ones,
they cannot be alleviated by importing measures that are conceptually
unsound. IRR draws on the same data and the same cut-off rate as NPV,
but the conversion of the data into a ratio rather than an absolute number
cannot improve the quality of the data.

The ultimate test of the value of a supplementary method is that it is

validly capable of qualifying the signal of the primary method, either by a)
reinforcing it, or b) by overriding it when the latter fails to reflect some
relevant dimension of investment worth. If it cannot perform either of these
two functions, and has a tendency at times to conflict with the primary
measure, then it serves no substantive function, and may in practice have a
negative impact on the decision process. Since IRR gives a misleading
signal about the acceptability of a project, its use as a supplement must be
clearly open to doubt.

The issue, therefore, is whether an estimate of the "maximum cost of

capital that a project can bear" can validly be used to qualify the signal
contained in NPV. The state IRR > k is a precondition of a positive NPV,
and therefore to argue that it reinforces the latter is tautological unless it
can be shown that the degree to which IRR exceeds k has relevance to the
interpretation of NPV. But this has already been shown not to be the case.
Both B2 and B3 in Table 2 have a greater IRR-k spread than project B1
but this does not make b1 any less desirable. It is true that the spread
between IRR and the equilibrium return indicates the degree of abnormality
in the investment’s rate of return, but this in itself is irrelevant to the
incremental significance of the investment.

If IRR cannot reinforce the signal contained in NPV still less is it

validly capable of countervailing it. However, one of the more plausible
arguments in favour of the method is that the IRR-k spread provides an
easily understood indicator of the degree to which a positive expected NPV
is vulnerable to errors in estimating k. This will now be considered.

IRR as an indicator of cost-of-capital uncertainty

It has already been noted that the argument that IRR has an advantage
in apparently not requiring a precise estimate of the cost of capital is
specious because, although it is calculable without reference to the cost of
capital, it cannot be used effectively without it. More persuasive,
perhaps, is the argument that because IRR indicates the maximum cost of
capital a project can bear, the IRR-k spread indicates the degree of tolerance
of the NPV to errors in estimating the cost of capital. This argument raises
three questions: a) is cost-of-capital risk relevant to project worth, b) if so,
is IRR-k spread the best indicator of it, and c) should the indicator be
factored into the calculation of NPV, or should it be treated as an addendum
to NPV?

A project may be viewed as having two types of risk, cash flow risk
and cost-of-capital risk, but standard NPV calculations may typically
reflect only the former. The possibility that the latter may also be
relevant, however, depends presumably on whether the risk can be shown
to be systematic. But, even if it is systematic, it is not clear that the IRR-k
spread is the best indicator of the effects of estimation errors. Every
project's NPV has unique sensitivity to changes in k, depending on the
configuration of the cash flows, and a more useful indicator is likely to
be achieved by sensitivity analysis of the respective NPVs under different
assumptions about k.

More significantly, however, even if IRR-k spread is a

useful indicator of cost-of-capital risk, the question arises whether this
information should be factored into the NPV calculation or whether IRR
should be presented as a supplementary method for the decision-maker to
judge its impact on NPV. If the former, then IRR is simply input into NPV,
one of several investment tools, and not a distinct measure of investment
worth. If the IRR-k spread is first incorporated into NPV, and IRR is
also presented as a separate investment statistic, this is clearly double
counting for cost-of-capital risk.

If the assumption is that IRR-k should not be factored into NPV but
presented as a separate statistic this raises the question why cost-of-capital
uncertainty should have such a unique role in the investment decision
process, given that the integrity of NPV is undermined when any relevant
aspect of risk is omitted from the calculation.4 It would be difficult to
claim that it is too problematic for the financial manager to incorporate
cost-of-capital risk into the calculation of NPV since the task would be
even greater for the decision-maker, who now is left with the task of
modifying the unadjusted NPV to capture the implications of the IRR-k
spread. The decision to omit any factor relevant to a project's incremental
value and then to present this factor as a rider to NPV not only imposes a
significant burden on the decision-maker but accords to that factor a
definitive role in the decision process. Even if IRR is intended by the
financial manager to be treated only as an addendum to NPV and not as a
full investment method, it would be unrealistic to assume that the
significance of this distinction would be recognised in practice without the
risk of provoking the dysfunctional effects associated with a multi-criteria
approach. It is perfectly legitimate to consider the sensitivity of NPV to
variations in the cost of capital, but NPV remains the only valid measure
of the project's incremental value. Presenting a range of NPVs may create
its own problems for the decision-maker but at least it remains consistent
with the single criterion ideal.

3.7.3 IS IRR EQUAL TO NPV AS AN ACCEPT-OR-

REJECT CRITERION?
When the issue is not to rank projects but simply to decide whether a
particular project is acceptable it is sometimes assumed that IRR is the better
method because, being expressed in percentage terms, it is likely to be
more effective than NPV in communicating a project's degree of
desirability. The conventional assumption is that the conceptual differences
between the absolute and relative form of the present value model are
unimportant in an accept-or-reject situation on the grounds that IRR nearly
always gives the same accept-or-reject decision as NPV (except when the
multiple yield problem arises). But the signals given by the two measures
are quite different. IRR is correct only in a yes-no sense. An essential test
of the theoretically correct measure of investment worth is that a higher
rating under the measurement system should denote a higher degree of
desirability. NPV meets this test because greater (risk-adjusted) wealth
is unequivocally more desirable than less wealth. IRR fails the test
because a project's desirability is not a function of the excess of its IRR
and the project's minimum acceptable rate (k). The fact that IRR exceeds k
for a given project is no more than a statement that the project has a positive
NPV. IRR may give a correct signal, therefore, about the acceptability
of a project, but it gives a misleading signal about the degree of
acceptability. It may seem unimportant whether decision-makers
misinterpret a project's degree of desirability if the project is acceptable
in any event, but equating IRR with the degree of desirability may have
serious dysfunctional consequences.

Thus, if the notion is conveyed that, in an accept-or-reject situation, IRR

signals the degree of project desirability, it would be difficult to convince
nonfinancial managers that, when mutually exclusive projects are being
compared, the project with higher IRR is not necessarily more desirable.

Secondly, and more fundamentally, the ranking problem, and

therefore the scale issue, cannot be avoided even in a single-project
context. Capital budgeting is a dynamic process, and throughout a
project's life the firm will continually seek to enhance the project's
investment value, since it may always be possible for management to
influence the subsequent configuration of the cash flows. When an
enterprise has some degree of control over the risk or timing of a project's
future cash flows, this is essentially no different from the problem of
discriminating between separate, competing projects. An individual project
in effect competes with itself. If the IRR-k spread were to be interpreted
as an index of desirability it should logically be assumed that any strategy
which would increase this spread would be desirable, and vice versa. This
could inhibit management, when faced with a high IRR, from seeking out
alternative strategies that would increase the project's NPV, or when faced
with a low IRR, induce them to sacrifice NPV in pursuit of a short-term
yield advantage. The logic of wealth-maximisation, however, is that any
opportunity to reschedule a project's cash flows in such a way as to increase
its NPV is beneficial even if the effect is to sacrifice IRR.

For example, if, having accepted a project with the cash flows equal
to B2 in Table 2, the firm found subsequently that it could alter the timing of
these flows to replicate those of project B1, then clearly this would be
advantageous, despite a lowering of the IRR. The firm would be
disinclined to make this change, however, if it perceived IRR as a measure
of desirability.
 In summary, the excess of a project's IRR over the cost of capital
indicates that the project has a positive NPV, but does not reflect the
project's degree of desirability. IRR is misleading even for accept-or-
reject decisions because it promotes the short-term perspective implicit in
the IRR method, and may lead to a subsequent mismanagement of the
project.

IRR in discriminating between projects with identical NPVs

This insight into IRR’s limitation as a measure of desirability allows

us to address one other claim for IRR, that it is useful in discriminating
between projects that happen to have identical NPVs. Of course, the same
could be said for Payback, or even for the toss of a coin, except that IRR
shares the same DCF framework as NPV. If it is accepted, however, that IRR
is a misleading indicator of a project's degree of desirability, it is incorrect to
assume that it can validly be used to discriminate between projects with
identical NPVs. It is clearly convenient to have a tie-breaker when NPVs are
the same, but the project with the higher IRR is only by chance more
desirable, just as is the one with the lower payback. Moreover, if the firm
were to treat IRR as the ultimate benchmark when NPVs are the same, it
makes it difficult subsequently to present a credible case to managers to
ignore IRR when the NPVs are different. The important point is that it is not
a matter of indifference when two projects have the same NPV. When faced
with dilemma, the choice should be made on the basis of the primary
decision rule, MAX PVtMAX NPVt. The primary task of business
enterprises is to create wealth. Hence the project with the greater scale
should be chosen rather than one indicated by an otherwise irrelevant
criterion. Hence the reason why D3 is to be preferred over D2 in Table 5.

3.7.4 IS IRR USEFUL UNDER RATIONING

CONDITIONS?

It has been shown that, for listed companies, conditions of capital

rationing should normally not exist. They could, of course, arise if self-
imposed, or in unlisted companies without access to outside capital. We
have shown that that the reinvestment opportunities for intermediate cash
flows are irrelevant under nonrationing conditions, but clearly they become
relevant if, for whatever reason, the firm does operate under rationing. Does
the relevance of reinvestment under these circumstances justify the use of
IRR? Is there not then the need for an efficiency measure rather than for the
absolute measure of NPV.

Even in rationing conditions the fundamental objective of maximising

PV subject to maximising NPV remains unchanged. The problem facing the
firm is to select the combination of investments that achieves this end.
Certainly this involves taking into account the reinvestment opportunities
created by the intermediate cash flows from its possible projects, but the
solution requires a sophisticated mathematical programming approach
outside the scope of this chapter. Simpler decision tools, such as IRR or PI
are sometimes suggested and these may be sufficient under simple rationing
conditions. The object is to maximise the combined NPV given the
budgetary constraints, and, at best, the PI and IRR are simply arithmetic
tools to aid the selection process. It is important to stress, therefore, that
even in these circumstances, the only relevant acceptance criterion is NPV.
Once the optimal combination of projects is selected their individual IRRs,
PBs and PIs are irrelevant.

3.7.5 IS IRR A USEFUL AID TO NONFINANCIAL

MANAGERS?

The common argument that a ratio, and therefore IRR, is more

understandable to nonfinancial managers confuses familiarity with
understandability, and ignores the fundamental issue of decision
relevance. Although the basic concept of yield is well understood, the
application of the concept to the product market exacts a heavy learning
burden on those facing its conceptual idiosyncrasies for the first time
- the reinvestment issue, the problem of multiple yields, the incremental
yield approach, the problem of accommodating differential short and
long-term interest rates, the problem of comparing yields of projects in
different risk classes, and the issue of scale. The notion that the concept is
more understandable is a myth. Coming to terms with these complexities
might arguably be worthwhile if the method could be shown to be an
acceptable substitute for, or to add relevant information to NPV. But,
because IRR is liable to contradict the decision indicated by NPV, then
annexing it to the latter allegedly to help the nonfinancial manager is
difficult to defend as a prudent or harmless expedient. The notion that the
method is a useful supplement on the grounds of being more
understandable is therefore illusory because paradoxically it can be
properly understood only when its fundamental irrelevance to the product
market is fully recognised. More importantly, the assumption that NPV
lacks intuitive appeal is misguided.

If you were to ask the average finance student to define NPV the
answer would be something like “If the investment outlay is deducted from
the discounted present value of the project’s future cash flows the difference
represents the net present value which, if positive, indicates that the project
is acceptable.” In effect, the natural tendency is to define the concept by
describing the method of its computation. This has become the practice in
textbooks and may make sense for examination purposes but it is of doubtful
help to the nonfinancial manager unfamiliar with the concept of discounting
cash flows. If we are going to make NPV more accessible to the general
user we must learn to define the method in terms of its significance rather
than of its method of computation. The fact that a project is expected to add
£5M to the value of the firm has more significance to the decision-maker
than how the measure has been derived. Indeed the very name net present
value suffers from the criticism that it focuses on the measurement process
rather than on the significance of the measure. If we denoted the measure
“Added Value” or “Incremental Wealth” it would become clearer to the
nonfinancial manager why the measure should take priority over all others,
and why a higher added value is always better than a lower added value
whatever the rate of return per pound invested.

3.7.6 CAN IRR SERVE EVEN AS A PRELIMINARY

SCREENING METHOD?

It is often argued that it is unnecessary to use the NPV method to

screen potential projects. IRR, it is claimed, and, even more commonly, the
Payback method, could be satisfactorily used to screen out projects before
the final analysis by the NPV method. This, of course, makes little sense.
To screen out some projects using a theoretically invalid method cannot be
defended even if could save a little time. It would have been a serious
matter if North Sea oil exploration companies had used Payback to screen
their long-term investments in the first instance. Payback and IRR both
involve estimating the same future cash flows as the NPV method. The
incremental time and effort in discounting those cash flows to determine the
respective NPVs is a small price to pay to avoid the risk of rejecting
worthwhile long-term projects. It is ironic that, on the one hand, it should be
claimed that investment projects are too important to be left to one method
and, at the same time, capable of being screened out by one inferior method.

3.7.7 IS IRR NOT A BETTER LINK TO THE RATE OF

RETURN IN SUBSEQUENT FINANCIAL REPORTING?

The conclusion that capital investment appraisal should be based

exclusively on an absolute measure of wealth unaccompanied by a relative
measure may appear overprescriptive given that the corporate financial
reporting system is rooted in profitability and rate-of-return measures
designed to help review the firm's past investment decisions. The inclusion
of IRR in the ex ante decision process has arguably the advantage of
creating a useful link with the subsequent review process since this tends
to be based primarily on rate-of-return concepts. It would be undesirable,
however, to allow ex ante investment choices to be driven by ex post
performance evaluations systems. It is possible, moreover, that, although
there should be a fundamental consistency between ex ante investment
choices and ex post analysis, a somewhat different perspective is
appropriate. It is outside the scope of this paper to consider optimal
performance evaluation or financial reporting systems, but the use of
achieved rates of return in retrospective analysis may be partly defended on
the grounds that the scale of the investment program has been substantially
determined for the period under review, that ex-post analysis is concerned
more with measuring the effectiveness of investment choices that have been
made than with evaluating choices that might have been made, and the
primary purpose of periodic review is to evaluate managerial performance
in respect of a given set of investments within a given time-frame. Ex ante
investment selection is concerned with evaluating possible project
alternatives over their total future lifespan. Therefore, the conventional
bias towards rate-of-return concepts in financial reporting cannot be
used to defend the use of a rate-of-return measure in capital budgeting,
otherwise it would be a persuasive argument for using the Accounting Rate
of Return.

3.8 WHY IS THE YIELD APPROACH

ACCEPTABLE IN THE SECURITIES MARKET BUT
NOT IN THE PRODUCT MARKET?
 Having dismissed IRR as an inappropriate under all circumstances
some comment is needed about the fact that the yield of an investment is
widely used in the securities market. Indeed it was from the bond market
that the concept of discounted cash flow was first imported in the last
century. IRR is simply another name for the yield to redemption of a bond.
Why is it that a percentage measure works satisfactorily in the bond market
but not in the product market? The explanation, of course, lies in the scale
effect. The scale problem does not arise in the securities market because
investors can choose to invest any amount they wish in a given security.
Investments in the real market, however, come in parcels, and it is not
possible to buy a quarter or half of a project. Therefore, whilst it is quite
legitimate to compare securities on the basis of the return per pound
invested, only an absolute measure of added value is relevant in the real
market to compare projects of different scale. The fact that IRR appears to
work at times for real investments does not alter the principle that a yield
approach is fundamentally unsuitable for capital projects.

3.9 CONCLUSION

A casual survey of most standard finance textbooks makes it evident

that investment appraisal is rendered unnecessarily complicated by attempts
to explain the problems associated with IRR and PB and even by efforts to
salvage them. This chapter has argued that these methods are not potentially
acceptable measures of worth that happen to have some flaws, but totally
irrelevant measures that confound rather than enrich the decision process.
The investment appraisal process could be made significantly more
straightforward if PV/NPV analysis were presented in the finance literature
as the only valid approach to the measurement of investment worth.
 APPENDIX

TABLE 1

PROJECT OUTLAY NPV PAYBACK

A1 £10M £1M 5 YEARS

A2 £2M £1M 3 YEARS
A3 £5M 0 2 YEARS
A4 £5M 0 6 YEARS

MUTUALLY EXCLUSIVE PROJECTS UNDER NONRATIONING CONDITIONS

TABLE2

B1 B2 B3 B4

Discount rate 10% 10% 15% 13%

YEAR

0 -2000 -2000 -2000 -1000

1 +10 +2100 +2500 -

2 - - - -

3 +3100 +330 - +1725

_____ ____ ____ ____
NPV +345 +156 +174 +198
IRR 16% 17% 25% 20%

MUTUALLY EXCLUSIVE PROJECTS WITH CONFLICTING SIGNALS FROM NPV AND IRR
 TABLE 3

PROJECT B1 PROJECT B2

PV PV
FACTOR PV FACTOR PV

YEAR 1 INVESTMENT £2000 1.00 £2000 £2000 1.00 £2000

YEAR 2 INTEREST 200 200

____ ____
2200 2200
CASH FLOW 10 2100
_____ _____

INVESTMENT 2190 .909 1991 100 .909 91

YEAR 3 INTEREST 219 10

_____ ____
INVESTMENT 2409 .826 1899 110 .826 90
_____ ____ ____ ____

EQUIVALENT ONE
YEAR INVESTMENT 5980 2181
____ ____

MEASURING THE SCALE OF AN INVESTMENT BY CONVERTING IT

INTO THE EQUIVALENT OF A ONE-YEAR INVESTMENT
 TABLE 4

PROJECT OUTLAY CASH INFLOWS NPV

________________________________ @10%
YEAR 1 YEAR2 YEAR3

C1 -£10M - - +£13.3M 0

C2 -£12M +£11M - +£2.7M 0

INTERMEDIATE CASH FLOW AND THE ISSUE OF REINVESTMENT

TABLE 5

PROJECT OUTLAY NPV PB IRR

D1 £5M £1.4M 3 YEARS 23%

D2 £100M £1.5M 4 YEARS 14%

D3 £500M £1.5M 10 YEARS 10.5%

THE “EFFICIENCY“ OF INVESTMENTS VERSUS THEIR NPV

3.10 SUMMARY
Conventional investment selection procedures tend to be influenced by the logic of capital
rationing even when nonrationing conditions are explicitly assumed to obtain. This tendency has
serious dysfunctional implications and can be attributed to a number of misconceptions and
inconsistencies that have entered into capital budgeting theory. These can be summarised as follows:

1. The scale of an investment is a function not only of initial outlay but also of cash flow pattern
and of project life. Consequently, every project has a unique scale. In normal, nonrationing
conditions the greater the scale of a project for a given NPV the better.

2. Zero-NPV investments are positively worthwhile in nonrationing, and possibly even in

rationing conditions. In a reasonably competitive environment, they may even form a significant
component of a firm's investment opportunity set. Indifference to zero-NPV investments is,
therefore, a form of self-imposed capital rationing and may lead to underinvestment.

3. Indifference to zero-NPV investments, and therefore a tendency to underinvest, can be traced

ultimately to the traditional share price maximising objective, which directs managerial attention
exclusively to the wealth accretion aspect of investment. The alternative goal of “maximising the
long-term value of the firm subject to maximising the share price” is more appropriate for
competitive markets because it encompasses both the wealth-creation and wealth-accretion
dimensions of investment.

4. Reinvestment opportunities for intermediate cash flows are irrelevant in assessing

project worth under nonrationing conditions. The common assumption that a project with a given
NPV is more beneficial for having a smaller rather than greater outlay, or a quicker rather than a
slower payback period on the grounds that capital is thereby released for further investment is
fallacious. When choosing between competing projects with identical NPVs, the project that
employs most capital is generally to be preferred because it creates more wealth for the same wealth
accretion.

5. The fundamental flaw in IRR as a criterion for evaluating competing projects is therefore not
related to any reinvestment assumptions inherent in the method, but can be attributed entirely to
the scale factor in investment. Because all projects are different in scale, IRR, as a ratio, is
intrinsically invalid, even when it happens to give the correct ranking. Even for accept-or-reject
investment decisions IRR is misleading because it suggests that the investment's cash flow recovery
should be managed, wherever possible, in such a way as to give the investment a high IRR rather
than a high NPVs.

6. A multi-criterion approach to investment appraisal is indefensible. The common practice of

using "efficiency" indicators, such as IRR and Payback, to supplement the NPV method is
misplaced, given that such measures confound rather than enrich the decision process. NPV is not
the best measure of investment worth, it is the only acceptable measure.
QUESTIONS

1. What characteristics should be possessed by the appropriate acceptance

criterion in capital budgeting decision-making?

2. In what sense can it be claimed that Payback is an anti-investment

criterion?

3. The internal rate of return is often criticised as a) sometimes generation

multiple yields and b) assuming reinvestment of the intermediate cash
flows at the internal rate. Explain why these criticisms are misplaced.

4. The Internal Rate of Return is widely used in the securities market in the
form of the redemption yield on bonds etc. Explain why the concept
cannot not validly be extended to the capital budgeting context.

5. Explain the importance of “scale” in assessing the significance of the

IRR.

6. It is commonly assumed that IRR is a perfect substitute for NPV in a

Simple accept-or-reject situation where no ranking is involved. Explain
why IRR does not provide a reliable index of project desirability even in
these circumstances.

7. The argument is sometimes made that more information is always better

than less, and therefore that the use of several acceptance criteria in
support of NPV always enriches the decision process. Discuss whether
this logic justifies the use of PB and IRR as ancillary measures of
investment worth.

8. How would you explain the significance of NPV to a manager who is

unfamiliar with the discounted cash flow concept?
PROBLEMS
1. Company One operates under normal, nonrationing conditions and is
presented with two competing projects. Which should it choose?
Explain your decision, and indicate what additional information you
might require?

A B
Outlay £50m £80m
NPV £4m £4m
IRR 18% 16%

2. Company Two is also presented with two competing projects under

nonrationing conditions. Which should it choose and why?

C D
Outlay £100M £100M
NPV 0 0
Payback 5 years 3 years

3. Company Three, again under nonrationing, is presented with the

following projects.

E F
YEAR 0 Outlay £100M £70M

YEAR 1 Cash Flows - 60M

YEAR 2 -do- £144M 40M

IRR 20% 30%

The company is confident that the cash inflow of £60M from project
F in year 1 could be reinvested at 30%. Consider which project the
company should choose, explaining your decision.
READINGS

TEXT BOOKS

All standard finance texts. These rather than journal articles provide the
best insight into the conventional interpretation of the share price
maximising objective and its implications for financial decision-making.
These include:

Brealey, R. and S. Myers, Principles of Corporate Finance,

McGraw Hill.

Brigham, Eugene F., Fundamentals of Financial Management,

Orlando, Florida, Dryden Press.

Copeland, T.E., and J.F. Weston, Financial Theory and Corporate

Policy, Addison Wesley

Gitman, L.J. Principles of Managerial Finance, Harper Collins

Publications

Moyer, R., J McGuigan and W. Kretlow, Contemporary

Financial Management, West Publishing Company.

Ross, S., R. Westerfield and J. Jaffe. Corporate Finance, Irwin.

ARTICLES

Dudley, E, Jr, (1972) "A Note on the Reinvestment Assumption in

choosing between Net Present Value and Internal Rate of Return", Journal
of Finance, September.

Gitman, l. and V. Mercurio, (1982) "Cost of Capital Techniques used by

Major U.S. Firms: Survey and Analysis of Fortune's 1,000," Financial
Management, Winter, pp. 21-29.
Haka, S.F., L. Gordon, and G. Pinches, (1985) "Sophisticated Capital
Budgeting Techniques and Firm Performance," The Accounting
Review, October, pp651-669.

Keane, S. M., (1979) "The Internal Rate of Return and the

Rein-vestment Fallacy", Abacus, Vol 15, No 1, pp 48-55.

Kim, S. H. (1982), "An Empirical Study of the Adoption of

Sophisticated Capital Budgeting Practices and earnings Performance”
Engineering Economist, Spring, pp. 185-196.

McIntyre, A. and N. Coulthurst, (1987) "The Planning and Control of

Capital Investments in Medium-sized Companies", Management
Accounting, March, p.39.

Moore, J.S. and Reichert, A.K. (1983) "An Analysis of the Financial
Management Techniques currently employed by large US
Corporations", Journal of Business Finance and Accounting, Vol 10, No 4
pp623-645.

Mukherjee, T. (1987) "Capital-Budgeting Surveys: The Past and the

Future", Review of Business and Economic Research, Spring pp 37-56.

Runyon L. R. "Capital Expenditure Decision Making in Small Firms",

Journal of Business Research (September, 1983) pp 389-397.

Solomon, E., 1956 "The Arithmetic of Capital Budgeting Decisions",

Journal of Business, April, pp 124-129.
 FOOTNOTES
1. As a measure of project scale it is noteworthy perhaps that the ratio of
NPV to ECI gives a better indication of the relative wealth-creating
efficiency of the project than IRR, which fails to reflect the risk-
adjusted wealth increment, and than the Profitability Index, which
incorrectly equates initial outlay investment scale.

2. See Dudley, E, Jr, "A Note on the Reinvestment Assumption in choosing

between Net Present Value and Internal Rate of Return", Journal of
Finance, September 1972, and Keane, S. M., "The Internal Rate of
Return and the Reinvestment Fallacy", Abacus, Vol 15, No 1, pp 48-
55, 1979

3. Of course if the purpose were say to compare the efficiency of two

divisional managers operating with different capital bases, then a
ratio is appropriate. But when the object is to measure the
contribution of each division's decisions to the value of the company, an
absolute measure of incremental value is the only acceptable criterion.