A Reliable Internal Rate of Return
The internal rate of return (IRR) is a widely used measure of financial evaluation. It is the discount rate for which a project’s benefits exactly equal its costs; in other words, it is the rate at which the project’s net present value (NPV) is zero. It is well known that the IRR suffers from two defects not found in the NPV criterion. First, choosing among projects based solely on the IRR may cause a project with lower NPV (and therefore lower absolute benefits) to be selected. The second defect of the IRR criterion is that a project with a mix of positive and negative cash flows over time does not have a unique IRR
To overcome these deficiencies, I suggest a reliable internal rate of return, the IRRr. The deficiencies discussed in the previous section can be overcome by making explicit a) the opportunity cost of funds (the discount rate) and b) the budget of the projects being compared. Indeed, a more elegant and informative method for finding an “internal rate of return” is to find that rate at which the initial investment would have to grow to yield the future value of the remaining cash flow –in other words, to find the rate of increase in real wealth generated by a project. This differs from the modified internal rate of return (MIRR) in that the IRRr allows the correct among projects while the MIRR may not. I prove that the IRRr will give the same answer as the NPV and only give one answer.
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