This method is popular because of its ease of understanding, and it concerns one variable and not two, such as in the case of the NPV rule. The IRR summarises an investment’s potential in one simple percentage and is subsequently easier to present on cash flow analysis. It does take into account the time value of money, which is generally a good basis for decision-making in the future.
Despite this popularity, the IRR does have its flaws as it can produce conflicting recommendations to the NPV. It also cannot accommodate any changes in interest rates that may occur over the project’s life. And, in projects with irregular cash flows, it can produce projects with either multiple IRRs or no IRR at all, as shown below.
Figure 1
In this scenario, there are negative cash flows, followed by positive cash flows, and then negative cash flows again. When cash flows move from negative to positive and then vice versa, the graph intersects the x-axis at two points, giving two values for the IRR. A discount rate below point A should cause the project to be rejected, and then so should a rate above B. This disregards the positive NPV values that occur in between points A and B.
Figure 2
In Figure 2, the graph does not intersect with the x-axis at all. This is because cash flows are positive at all values of the discount rate. This can prove to be a major error of the IRR in its analysis.
The Accounting Rate of Return
This is the average earnings of the project after tax and depreciation have been deducted, divided by the investment’s average book value during the course of its life. It is a non-DCF method, because it does not take cash flows into account, but looks rather at earnings.
This particular method is easy to understand and as a result, is widely used. Net income is usually readily available for use in calculations, making it a convenient choice. A key disadvantage of the ARR however, is again; it does not take the time value of money into account. This is a critical concept as “A dollar today is worth more than a dollar tomorrow” (Himmel, 1999). It also uses net income as opposed to cash flows, which can be misleading when trying to analyse the potential merits of an investment, because it does not look at the expenditure of the project.
The Payback Period
The final method of appraisal is the Payback Period. This is “the amount of time required for the cash inflows from a capital investment project to equal the cash outflows” (Timeweb, 2006). A certain cut-off date can be set as a target for the PP or merely the project with the lowest PP can be taken. Ultimately, the shorter the payback period, the better.
This is a very simple-to-use method, and is commonly used to support other methods, predominantly when the cash flows are expected to be constant over several years. It helps to minimise risk by giving a greater weight to earlier cash flows. However, it does promote the acceptance of short-term projects, implying liquidity, which does not increase firm value. It also ignores cash flows that occur after the Payback Period itself. This negates the possibility of negative cash flows in future, or the fact that greater profit may be expected on a more long-term basis. This makes the overall profitability of the project an obsolete measure. With an arbitrary cut-off date, there are no grounds for a comparable guide.
What do firms prefer?
Over the years, there have been various studies on which investment appraisal techniques managers prefer to use. Richard Pike undertook separate studies in 1975, 1980, 1986, and 1992, that measured the uptake of the four appraisal techniques by 100 managers of large firms (see appendix). Arnold and Hatzopoulos in 1997 also conducted a similar survey on investment appraisal using a mixture of large, medium, and small-sized firms.
Pike found that historically, most managers preferred not to use the NPV rule as compared to using the Payback Period approach and, in particular, the IRR. However, these results have gradually changed over time. The tendency to avoid the NPV has relaxed, and it has become a much more popular method of appraisal in recent years. He suggested that computer spreadsheets have made calculating the NPV much easier and so have subsequently made it more popular. In that sense, the development of technology has positively aided the growth and usage of the NPV method.
Arnold et al found that in 1997, as much as 97% of managers in large firms used the NPV method, a 200% increase from the 1975 levels researched by Pike. Whereas the non-DCF methods of ARR and Payback Period achieved no rise in uptake, with just 55% of managers in 1997 using ARR and 66% using Payback. King (2001) points out however, that despite showing how many managers adopt each technique, these studies provide
“very little knowledge about how managers use these four techniques in the decision making process.”
In a separate study, Scapens and Sale (1981) found that 84% of US firms used DCF methods, which is a much greater percentage than UK firms. They attributed this to a national management environment tendency to favour more accurate techniques. Higgins (2001) points out that across many countries the adoption of DCF methods differs, with South Korea amongst the largest uptake globally.
Firms tend to vary their respective approaches according to their financial objectives. The NPV is favoured when firms intend to maximise shareholder wealth, and the Payback Period is favoured by managers who want to recover their investment as soon as possible on a short-term basis (Levy, 1998). Arnold et al also surveyed smaller firms, and found that they used NPV less than the larger firms (71% compared to 97%). This could be explained by a differing of objectives or merely a lack of knowledge amongst the decision makers.
DCF or non-DCF?
There is an active debate amongst academics and practitioners as to the relative virtues of using a DCF or non-DCF based form of analysis. DCF is often considered the more reliable due to its more accurate usage of cash flows, and then subsequently discounting them as they occur. However, non-DCF methods are quicker and easier to use, so generally being the favoured choice for people who want instant decisions. In modern times, there is a tendency to use both forms of methods, but the sustained accuracy of DCF methods gives them the edge. As shown by the research undertaken by both Pike and Arnold et al, there has been a significant rise in the proportion of managers using DCF techniques.
IRR or NPV?
The NPV tends to rely upon two variables: the discount rate and the beta (a measure of the volatility of the company in relation to the market as a whole, see appendix). The IRR, on the other hand, relies solely upon the discount rate. This means that the NPV is more susceptible to changes in exogenous factors such as interest rates and inflation, potentially marring the accuracy of the calculations. The volatility of the beta represents another issue.
However, the IRR only tends to work for independent projects, and not mutually exclusive ones. In some cases, a project with a higher NPV can produce a lower IRR and vice versa, as is the case in Figure 3.
Figure 3
In this scenario, project A should be taken, because it has a higher NPV, despite project B having a higher IRR. These are mutually exclusive projects, i.e. you can take either A or B or neither, but not both. In independent cases, you would be able to select both A and B. Here, you can see the limitations of the IRR in respect to the NPV.
Despite its theoretical foundation, the NPV rule can be considered difficult to use, and the IRR is much simpler and easier to define. However, what it makes up for in simplicity, it lacks in overall reliability. There are too many situations where the IRR can produce inconsistent results, as illustrated above, and the NPV provides a more reliable outcome.
In conclusion, the NPV rule is widely considered by managers and academics alike to be the best and most reliable form of investment appraisal. However, the issue of which method is best is a topical one. Who can define what the best method is? When referring to the ‘best’, what factors are to be taken into account? The NPV rule has become more commonly adopted by firms in the past few years due to the greater theoretical grounding that it provides. It gives a more accurate portrayal of an investment’s merits than the other three methods do. Despite this, however, all the three other methods do have their virtues and they have value in that they can be used either alongside the NPV rule or as a separate guideline, depending on the investment situation.
References
ARNOLD & HATZOPOULOS, (2000), The Theory-Practice Gap in Capital Budgeting: Evidence from the United Kingdom, Journal of Business Finance & Accounting, Volume 27, pp. 603-627.
HIGGINS, J., (2001), An Investigation into Investment Appraisal in Practice. Postgraduate Dissertation.
HIMMEL, J., (1999), Today is Worth More Than Tomorrow [online], Available from: [Accessed 3rd March 2006]
INVESTORWORDS.COM, (2005), beta definition [online], Available from: [Accessed 3rd March 2006]
IRONS, A., (2004), Managing Finances [online], Available from: [Accessed 3rd March 2006]
KING, W., (2001), What Investment Appraisal Techniques do Companies Use? Postgraduate Dissertation.
LEVY, H., (1998), Principles of Corporate Finance: 2nd Edition. South-Western College Publishing.
PIKE, R., (1982), Capital Budgeting in the 1980s, Chartered Institute of Management Accountants.
PIKE, R., (1983), A Review of Recent Trends in Formal Capital Budgeting Processes, Accounting and Business Research, Summer, pp. 201-208.
PIKE, R., (1988), An Empirical Study of the Adoption of Sophisticated Capital Budgeting Practices and Decision Making Effectiveness, Accounting and Business Research, Autumn, Volume 18, Number 72, pp. 341-351.
PIKE, R., (1996), A Longitudinal Survey on Capital Budgeting Processes, Journal of Business Finance & Accounting, Volume 23, Number 1, pp.79-92.
ROSS, S.A., WESTERFIELD, R.W., & JAFFE, J. (2005). Corporate Finance: 7th Edition. McGraw Hill.
TIMEWEB, (2006), Investment Appraisal [online], Available from: [Accessed 24th February 2006]
Appendix
Results from the surveys of Richard Pike in 1975, 1980, 1986, and 1992.
(Source: Pike, R.H., 1982, 1983, 1988, 1996.)
Definition of the beta
A quantitative measure of the volatility of a given stock, fund or portfolio, relative to the overall market. A beta above 1 is more volatile than the overall market, while a beta below 1 is less volatile.
(Source: investorwords.com)
Formulae
Net Present Value = - Investment + X1 + X2 + X3 + …..
(1+r) (1+r2) (1+r3)
(Where X is the cash inflow each year and r is the discount rate)
IRR is discount rate when NPV = 0
ARR = Average Net Income
Average Investment
Payback Period = Years taken for initial investment to be recuperated.