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**Carlo Alberto Magni
**

Department of Economics, University of Modena and Reggio Emilia CEFIN- Center for Research in Banking and Finance, Department of Business Administration, University of Modena and Reggio Emilia

The Engineering Economist, volume 55, number 2, pages 150-180, 2010

Updated version: January 14th 2012

Eugene L. Grant Award by the Engineering Economy Division of the American Society for Engineering Education as best paper published in The Engineering Economist in 2010

Abstract. The internal rate of return (IRR) is often used by managers and practitioners for investment decisions. Unfortunately, it has serious flaws: among others, (i) multiple real-valued IRRs may arise, (ii) complex-valued IRRs may arise, (iii) the IRR is, in general, incompatible with the net present value (NPV) in accept/reject decisions (iv) the IRR ranking is, in general, different from the NPV ranking, (v) the IRR criterion is not applicable with variable costs of capital (vi) it does not measure the return on initial investment, (vii) it does not signal the loss of the entire capital, (viii) it is not capable of measuring the rate of return of an arbitrage strategy. The efforts of economists and management scientists in providing a reliable project rate of return have generated over the decades an immense bulk of contributions aiming to solve these shortcomings. This paper offers a complete solution to this long-standing unsolved issue by changing the usual perspective: the IRR equation is dismissed and a new theory of rate of return is advanced, endorsing a radical conceptual shift: the rate of return does not depend on cash flows, but on the invested capital: only as long as the capital is determined, a rate of return exists and is univocally individuated, by computing the ratio of income to capital. In particular, it is shown that an arithmetic mean of the one-period return rates weighed by the interim capitals invested is a correct economic rate of return, consistent with the NPV. With such a measure, which we name ”Average Internal Rate of Return”, complex-valued numbers disappear and all the above mentioned problems are wiped out. The traditional IRR notion may be found back as a particular case.

Keywords. Decision analysis, investment criteria, capital budgeting, rate of return, capital, mean.

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Electronic copy available at: http://ssrn.com/abstract=1542690

Introduction

The inception of the internal rate of return (IRR) traces back to Keynes (1936) and Boulding (1935, 1936a,b). 1 This index is massively used as a tool for decision-making by scholars, managers, analysts, practitioners, and is taught to every student of any business and management school. The IRR decision criterion suggests to accept a project if and only if the IRR is greater than the cost of capital (usually, the market rate) and to rank competing projects via their IRRs: the higher a project, IRR the higher its rank. Unfortunately, the IRR gives rise to serious conceptual and technical problems: (i) a real-valued IRR may not exist, so that the comparison with the cost of capital is not possible; (ii) multiple IRRs may arise, in which case the above mentioned comparison is problematic; (iii) compatibility with the Net Present Value (NPV) is not guaranteed, not even if the IRR is unique;2 (iv) the IRR ranking is not equivalent to the NPV ranking; (v) the IRR may not be used if the cost of capital is variable over time; (vi) the IRR cannot measure the return on initial investment (vii) the IRR is not capable of signaling the entire loss of investment ( ); (viii) the IRR is not capable of measuring the rate of return of an arbitrage

strategy. The economic and managerial literature has thoroughly investigated the IRR shortcomings and a huge amount of contributions in the past 75 years have been devoted to searching for corrective procedures capable of healing its flaws (e.g. Boulding 1935, 1936b, Samuelson 1964; Lorie and Savage 1955; Solomon 1956; Hirshleifer 1958; Pitchford and Hagger 1958; Bailey 1959; Karmel 1959; Soper 1959; Wright 1959; Kaplan 1965, 1967; Jean 1968; Arrow and Levhari 1969; Adler 1970; Ramsey 1970; Norstrøm 1967, 1972; Flemming and Wright 1971; Aucamp and Eckardt 1976; Bernhard 1967, 1977, 1979, 1980; De Faro 1978; Herbst 1978; Ross, Spatt and Dybvig 1980; Dorfman 1981; Cannaday, Colwell and Paley 1986; Gronchi 1986; 1987; Hajdasinski 1987, 2004; Promislow and Spring 1996; Tang and Tang 2003; Pasqual, Tarrío and Pérez 2000; Zhang, 2005; Kierulff 2008; Simerská 2008, Osborne 2010, Pierru 2010). In particular, Pitchford and Hagger (1958), Soper (1959), Kaplan (1965, 1967), Gronchi (1986) individuate classes of projects having a unique real-valued IRR in the interval .

Fisher (1930) has introduced what is usually called “Fisher’s rate of return over cost” whose meaning is just the IRR of the difference between two cash-flow vectors. 2 For example, the cash flow stream has a unique IRR equal to 50%. According to the IRR criterion, the project must be accepted if the market rate is smaller than 50%, but the NPV is negative for any rate different from 50%, so the project is not worth undertaking. (Note that this example implicitly introduces a further class of problems: if a project is not unambiguously individuated as either an investment or a borrowing, the IRR profitability rule introduced in section 1 below is ambiguous.)

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Electronic copy available at: http://ssrn.com/abstract=1542690

Jean (1968), Norstrøm (1972), Aucamp and Eckardt (1976), De Faro (1978), Bernhard (1979, 1980) individuate classes of projects with a unique IRR in the interval and Levhari Karmel (1959), Arrow

(1969), Flemming and Wright (1971), Ross, Spatt and Dybvig (1980) use the

assumption of project truncability in order to make the IRR unique. Teichroew, Robichek and Montalbano (1965a,b) and Gronchi (1987) circumvent the IRR problems by using a pair of different return rates applied to the project balance depending on its sign (one of which is the market rate itself). The notion of relevant internal rate of return has been studied by Cannaday, Colwell and Paley (1986), Hajdasinski (1987) Hartman and Schafrick (2004). Issues related to the reinvestment assumptions in the IRR criterion and the adoption of the Modified Internal Rate of Return have been analyzed in several contributions, among which Lorie and Savage (1955), Lin (1976), Athanasopoulos (1978), Lohmann (1988), Hajdasinski (2004), Kierulff (2008) (see also the historical perspective of Biondi 2006). No complete solution to the issue has so far appeared in the literature. Among the proposals, Hazen’s (2003, 2009) approach stands out for the insights it conveys on the problem. The author makes use of the notion of ‘investment stream’, which is the stream of capitals periodically invested in the project (we will henceforth use the expression ‘capital stream’). He shows that the problems of uniqueness and nonexistence of the IRR are overcome by considering that any IRR is univocally associated with its corresponding capital stream. One just has to compare the real part of the (possibly complex-valued) IRR with the market rate, and a positive sign signals profitability if the project is a net investment or value destruction if the project is a net borrowing. However, some important (theoretical and applicative) issues remain unsolved: complex-valued return rates and complex-valued capitals are devoid of economic meaning project ranking with the IRR is not compatible with NPV ranking the IRR cannot measure the return on the initial investment the IRR decision rule may be applied only if the cost of capital is constant the IRR does not exist if the capital is entirely lost or if an arbitrage strategy is undertaken

Also, Hazen’s solution brings about a new problem: while any IRR may be used for decision-making, one still does not know which one of the IRRs is the economically correct rate of return 3

Electronic copy available at: http://ssrn.com/abstract=1542690

This paper offers a complete solution to all the IRR problems and, at the same time, calls for a paradigm shift in the notion of rate of return. The basic idea is that, in principle, the notion of rate of return is inextricably linked to the notion of capital: in order to determine the project’s rate of return, the evaluator must select the capital invested in the project. Mathematically, the evaluator has complete freedom for the selection of the capital invested and for the financial interpretation of the project: as a result, any project may be seen, at the same time, as a net investment or as a net borrowing of any monetary amount. Any sequence of capitals (capital stream) univocally determines a sequence of one-period IRRs (internal return vector). The corresponding arithmetic mean is shown to represent an unfailing economic yield, here named ‘Average Internal Rate of Return’ (AIRR). A project is then associated with a return function which maps capital into rates of return. There are infinite combination of capitals and rate of return leading to the same NPV; a specified return rate for a project is singled out only once the appropriate capital has been selected. And the choice of the appropriate capital depends on the type of project (industrial project, financial portfolio, firm) and on the type of information required (return on initial investment, on aggregate investment, on total disbursement, etc.). The approach purported in this work is computationally very simple and gets rid of complex-valued roots of polynomials for it defines a rate of return is a rather natural way: income divided by capital; it admits of a straightforward economic interpretation as the project’s profitability is reduced to its basic ingredients: (i) capital invested, (ii) rate of return, (iii) cost of capital. The AIRR may then be interpreted as the unique real-valued rate of return on the capital invested in the project. The paper is structured as follows. Section 1 presents the mathematical notation and provides the notions of capital stream and internal return vector along with the notion of return as well as the recurrence equation for capital. Section 2 summarizes the approach of Hazen (2003) which essentially consists of deriving capital streams from the project’s IRRs. Section 3 deals with accept/reject decisions: the IRR equation is dismissed and complex-valued numbers are swept away: the AIRR is defined as “income divided by capital”: its consistency with the NPV is shown by applying the notion of Chisini mean to a residual income model. Hazen’s decision criterion follows as a particular case of the AIRR criterion. Section 4 shows that the IRR is not a period rate, contrary to what believed by scholars and practitioners, but a weighted average of (generally 4

Evidently. if the project is a Let . Section 5 presents a condition under which the weighted average is a simple arithmetic mean. in particular. The net present value (NPV) of project where is the market rate. it is profitable if and only if 4 . computes the rate of return on the initial investment. The IRR profitability rule may be stated as If the project is an investment. Section 8 presents a condition under which the simple arithmetic mean may be used for ranking projects. An internal rate of return for project x is a constant rate is the same. so that in some situations one does not know whether the IRR acts as a rate of return or a rate of cost (see footnote 1). it is a particular case of AIRR. Mathematical notation and preliminary results of cash flows (monetary is ∑ A project or cash flow stream is a sequence values). Section 7 shows that a standardized AIRR correctly ranks a bundle of projects: the AIRR ranking is the same as the NPV ranking. it is profitable if and only if borrowing. which . such that .varying) period rates. 3 5 . 1.3 The net future value (NFV) is the future value of at some future date: We say that a project is profitable (or is worth undertaking) if and only if this is equivalent to for every t. that is. Section 6 shows that the AIRR may be interpreted as the rate of return of the project obtained from the original one by reframing it as a one-period project and. and let The approach is compatible with a bounded-rationality perspective: in this case is a subjective threshold (Magni 2009b). follows: ∑ or. . Some remarks conclude the paper. Section 9 provides a discussion on the paradigm shift triggered by the new theory and on its applicative content. 4 The IRR rule is semantically not satisfactory because it is not associated with a univocal definition of investment/borrowing.

Hajdasinski. If with where . the capital the return rate . is also known as project balance (Teichroew. the capital . Any project may then be viewed as a portfolio of T one-period projects. 1962. which is paid off to (or by) the investor. Gallo and Peccati 1993). for (1b) may be reframed as as the unique IRR of project 6 . Given that . Peccati 1989. outstanding capital (Lohmann 1988. The return is often called increases) by the amount income in business economics and accounting (Lee 1985. Robichek and Montalbano 1965a. Equation (1) is called ‘clean surplus relation’ in accounting (see Brief and Peasnell 1996). and vector. 1988). The capital increases by the return generated in the period but decreases (or . . the equality ∑ holds. (1a) may be framed as is the period rate of return. so the term is the return generated by the project in that period. eq. Any such project represents an investment (or borrowing) of amount which generates an end-of-period payoff equal to . irrespective of the capital stream . unrecovered capital (Lohmann. Penman 2010). Equation (1b) may be economically interpreted in is invested (or borrowed) at the following way: at the beginning of every period. The possibility of splitting up any multi-period project into T one-period projects is conspicuous: it opens up the opportunity of interpreting . and may also be interpreted as the book value of the project (therefore.b).with The term represents the capital invested (or borrowed) in the period . where is the null at time t 1. the return rate is interpretable as an accounting rate of return). Any vector Consider one-period project satisfying (1) is here labeled ‘capital stream’. 2004). unrecovered balance (Bernhard.

the author considers the capital stream the IRR. an IRR (if it exists in the real interval) is only a . so that summarized in the following Theorem 2. If a real-valued IRR exists. compute the corresponding capital stream and calculate its present value to ascertain its financial nature (investment or borrowing) 7 . . There are infinite sequences real-valued numbers that satisfy . It is easy to see that such an equation leads to . Hazen’s (2003) criterion: from IRRs to capital streams Hazen (2003) focuses on multiple roots drawn from the classic IRR equation. the corresponding internal return vector is univocally determined. whereas in the latter case an IRR is a rate of cost.1. Letting . In particular. Magni 2009a). See also Hazen 2009). . solve the IRR equation and pick any one of the IRRs b. Peasnell 1982. particular case of internal return vector such that all components are constant: It is important to underline that the internal return vector and the capital stream are in a biunivocal relation. once the capital stream is (exogenously) fixed. (the latter allows one to accept ∑ and using the terminal condition sequence ). In the former case. project is profitable if and only if is profitable if and only if derived from . project . 2.1 entails that the analyst should follow the following steps: a. Theorem 2. one gets ∑ . which means that the of one-period IRRs represents an internal return vector (see of Weingartner 1966. Peccati 1989.or. Then. which is the same. The project is a net investment if an IRR is a rate of return. Suppose (i) if (ii) if where ∑ { } is an IRR of project . Theorem 4. The decision criterion the author proposes may be (Hazen 2003. a net borrowing if .

Equation (3) shows that the NPV of the project is obtained as the product of two factors: (i) the (discounted) difference between a project IRR and the market rate. In a similar vein. for the IRR is an incorrect rate even if it is unique (see section 7). The choice of which root to use is immaterial. (ii) the present value of the IRR-derived capital stream. In the next sections we show that allowing flexibility Unfortunately. and without such an interpretation it would be hard to justify any economic recommendation without resort to other performance measures such as present value” (p. 5 because to every root k there corresponds a unique NPV may be written as . While Theorem 2. but the economic significance of the result is obfuscated: “We are currently unaware of an economic interpretation of complex-valued rates of return and complex-valued capital streams. this multiple description of a project is computationally unfailing and economically meaningful: the NPV does not change under changes in the project description. 1988.c. eq. ( ) This unfolds the opportunity of depicting the project in different ways: for each internal rate of return ( . let IRRs and let and and be any two real-valued be the corresponding capital streams. the author successfully deals with complex-valued IRRs as well (see his Theorem 5). Theorem 1. this solution does not heal the IRR flaws. . 5 8 . The left-hand side of (3) is invariant under changes in the IRR. That is. Then. Lohmann. (43)).1 is quite successful in accept/reject decisions. so that complex-valued numbers may not be dismissed and competing projects may not be correctly ranked. the project may be interpreted as a net investment (borrowing) of amount ) with rate of return (cost) equal to . for the project (see Hazen. Furthermore. Far from generating ambiguity. 44). it still does not tell the analyst which one of the IRRs is the correct rate of return for the project. accept the project if and only if the IRR is greater (smaller) than the market rate. but does not allow for a sufficient degree of freedom. This criterion brilliantly solves the problem of multiple roots. 2003. if the project is an investment (borrowing).

the residual income becomes . that is. The use of AIRR in accept/reject decisions We first provide a generalization of eq. 3. Reminding that ∑ . The notion of excess of what could be earned by investing the capital residual income is well-known in managerial accounting and value-based management (Edwards and Bell 1961. it measures the return in at the market rate . 2009a. (3). so we henceforth call it “residual rate of return” (RRR) . Young and O'Byrne 2001.on the capital stream solves all the problems: one chooses a capital stream and a unique rate of return is computed. Also. Pfeiffer and Schneider. Lemma 3. Martin and Petty 2000.1. By replacing rate of return . If ∑ for every . Petty and Rich 2003. Egginton 1995. and the IRR-determined capital stream is just one choice of an capital stream among 9 . Martin. Peasnell 1982. Then. is defined so that (4) may be framed as measures the residual income per unit of capital with an internal invested. See Magni. ∑ ∑ ∑ ∑ ∑ ∑ ∑ (QED) The term in (4) represents a “residual income”. (1). Consider an arbitrary capital stream equality holds: ∑ . the following Proof: By eq. ∑ for . Lohmannn’s marginal return is then a particular case of residual income. The margin . 2007. which Lohmann (1988) labels “marginal return”. Pfeiffer 2004. for a review).

(4) holds whatever the choice of only a particular case of it. project . That is.1.1 and Theorem 3. the investor univocally determines the capital stream (and. project is a net investment and is profitable if and only if ̅ is a net borrowing and is profitable if and only if ̅ is value-neutral (i. hence. From a computational and conceptual point of view. It is important to stress that the AIRR itself is 10 . and the rate of return is consequently computed.1 and eq.1 from a formal point of view. ). and the weights are given by the (discounted) capitals. In other words. (5). replaced to each one-period rates in the residual-income expression. Theorem 3. For any capital stream (i) if (ii) if (iii) project . eq. we search for that constant return rate ̅ which. The average rate ̅ is a reliable return rate because Theorem 3. In contrast. Hence. a radical departure from Theorem 2. (3) is Now we search for a Chisini mean (Chisini 1929. Contrasting Theorem 2. NPV = 0) if and only if ̅ Proof: Owing to Lemma 3.1 just says that the product of (̅ ) is invariant under changes in . the equality (̅ )∑ ̅ (QED) holds for any arbitrary capital stream.e. we note that the margin is replaced by the residual rate of return ̅ . in other terms. the thesis follows immediately. therefore. and eq.1 is consummated: the latter presupposes that the decision maker solves a T-degree equation in order to find a (real-valued or complex-valued) IRR. We are now able to prove the following Theorem 3. the AIRR replaces the IRR.1 leaves the decision is univocally maker free to choose a desired capital stream . Graziani and Veronese 2009) of the oneperiod IRRs.infinite possible ones. generates the project NPV: from ∑ one gets ̅ ∑ ∑ ∑ ∑ ̅ The mean ̅ is an average of the one-period IRRs. whence an internal return vector individuated. We name this mean ‘Average Internal Rate of Return’ (AIRR).

1. Remark 3. where income and capital are intended as aggregate income and aggregate capital (in present value terms). no complex- is the area of any rectangle with base ̅̅̅̅ and height | ̅ internal return vector and computing the Chisini mean of the one-period rates valued roots ever appear: only real numbers come into play. the AIRR is nonetheless defined. just consider that (6) which means that the AIRR is a (hyperbolic) function of equation ∑ has infinite solutions. The AIRR is greater (smaller) than the market rate for every positive (negative) determines the NPV: precisely. so any given . 11 .6 Remark 3. Eq.1 and the notion of Chisini mean. To see it. (6’) just says that the AIRR is the sum of a normal rate of profit (cost of capital) and an above-normal rate of return: we have ∑ . While the return is not defined if . complex-valued numbers are removed a priori so that economic intuition is always preserved. (7) is the founding relation for the new theory: it says that a rate of return is given by “income divided by capital”. |.invariant under changes in . with the precise meaning of return rates. Owing to Lemma 3. For any fixed the is associated with infinitely many capital streams which give rise to the same AIRR. as long as the denominator is nonzero. Using the notion of .2. (̅ ) The triplet ̅ univocally Graphically. Figure 1 illustrates the graph of the AIRR function for a positive-NPV project. 6 Economic intuition behind complex rate is investigated in Pierru (2010). which means that the aggregate income generated by the project is the sum of a normal profit (obtained by applying the cost of capital to the capital invested in the project) and an above-normal profit. we may write ̅ ∑ so the AIRR is well-defined even if some capital is equal to zero. as long as implies ̅ is unvaried. In other words. for is well-defined for every . Eq.

compute the corresponding one-period return rates and their average or directly use the shortcut (6’) to compute the AIRR c. the time-1 project NPV. p. the AIRR is always greater than the market rate for positive smaller than the market rate for negative (i. The project NPV is 12 . accept the project if and only if the AIRR is greater (smaller) than the market rate. pick an appropriate capital stream invested in the project) b. and EXAMPLE Consider the cash flow stream studied by Hazen (2003. the steps an analyst should follow are: a. (the one which reflects the true capital ̅ ̅ ̅ Figure 1. supplies the project’s excess income per unit of capital invested. so the project is not market rate equal to 10% is assumed. Computationally.that is. divided by the capital invested in the project . Equation (6’) is a useful shortcut: it enables to compute the project rate of return without computing all period rates of return. which. an income in excess of the normal profit.. The graph of the AIRR function for a positive-NPV project. where a . No matter which capital stream one chooses. if the project is an net investment (net borrowing).e. essentially. 44). Now. the project is worth undertaking). the excess income is.

Again. at discretion. by Theorem 3. which is greater than the market rate 10%. As for the second choice. Any of the corresponding AIRRs provides correct information: for example. by Theorem 3.1. the project is not worth undertaking. one may more conveniently choose. the project is deemed unprofitable. As for the third pattern.91 = 3.45 34. which is greater than the market rate so the project is seen as a net .1. . Instead of focusing on the complex-valued IRRs and calculating the complex-valued capital streams (whose economic meaning is obscure). the project is not worth undertaking. which.55 72.profitable. Analogously for the fourth case.55. No real IRR exists. Table 1 collects four arbitrary capital streams. Table 1.00 10 1 30 2 25 AIRR (%) Market rate (%) 13 .27 10 0 316. applied to the amount invested 4. Note that in any possible case the product of the RRR and the present value of the capital stream is invariant under changes in vector : for example. borrowing at a rate of cost of ̅ ( ) . Hence. leads back to the NPV: Analogously in any other case. the first pattern is such that ( ) . a capital stream and then compute the corresponding (real-valued) AIRR.56 10 4. we find ( ) so the project is depicted as a net borrowing. leads to the time-1 NFV 82% 4. real-valued AIRRs Time Cash Flows NPV 0 10 3.39 10 Period rate 10 Period rate 10 Period rate (%) 10 Period rate (%) 6 140% 20 0% 28 80% 0 200% 10. in the first case the RRR is 82%. where eq.7% 0 undefined 10 27. (6’) or eq. which. this means that the project is framed as a net investment.55 0. discounted by one period. (7) can be used for computing the AIRR.12 10 8.18 55. but two complex-valued IRRs exist: and . For illustrative purposes.39.7% 0 25% 0 15. Complex-valued IRRs. because the AIRR (now interpreted as a rate of cost) is ̅ 10%. The AIRR is ̅ which is smaller than the market rate 10%.

more 14 . Definition. We first need the notion of PV-equivalent capital streams. A (real-valued) IRR is a particular case of AIRR generated by a Hotelling class of capital streams. any other PV-equivalent capital stream supplies the same AIRR and the same answer on desirability of the project: the project is worth undertaking. . (6) is identical to eq. Its associated internal return vector is which leads to ̅ . so there exist infinite capital streams which give rise to that IRR as the AIRR of the class.1 allows us to set aside the traditional interpretation of the IRR as that constant rate of return which is applied to the capital periodically invested in the project.e. EXAMPLE Consider the cash flow stream has a unique real-valued IRR equal to and assume the market rate is 5%. since. Now. Theorem 4.4. (3). it is obvious that the AIRR generated by ∑ . There are infinitely many capital streams in the same class that lead to ̅ The assumption of constant rate leads to with . the AIRR does not depend on is unvaried. The IRR is. which is obviously associated . so that ̅ . because there exist many infinite vectors that fulfill the equation ∑ is itself. as seen above. For such capital streams. for ̅ . as can be easily verified. Another PV-equivalent capital stream is . whence . . that is. But any capital stream contained in the same class as long as generates the same AIRR. for . ̅ ( ) for any contained in the Hotelling class. This IRR is but the AIRR corresponding to the . i. That is. This class contains infinite elements. eq. We call this class ‘Hotelling class’ (after Hotelling 1925).1. An element of Hotelling class. The class contains infinite elements. which generates the internal return vector ̅ . the set of those capital streams such that this class is . We have then proved the following Theorem 4. The IRR as a particular case of AIRR We now show that the IRR is just an AIRR associated with a specific class of capital streams. We stress that is only one element of the class. Two or more capital streams are said to be PV-equivalent if they have equal Consider the class of those capital streams which are PV-equivalent to . The project .

the first three capital streams are PV-equivalent and belong to a Hotelling class: ̅ ( ) ( ) ( ) so the AIRR is the same: . the constant internal return vector is only one among other ones contained in the Hotelling class. Among the other five capital streams. an average AIRR corresponding to infinitely many PV-equivalent capital streams. collected in Table 2. The fifth one is such and are stream determined by the assumption of constant period rate equal to that ( ) ( and ̅ ) ( . The cash flow stream is and . Figure 2 depicts the graph of the AIRR function associated with this project. And given that Theorem 3. We and the real-valued IRRs are .properly. the AIRRs associated with the borrowing-type (investment-type) description are greater (smaller) than the market rate. We stress again that the areas 15 . Section 7. In particular. Assuming a market rate equal to . the appropriate class of capital streams). The last capital stream is .1 tells us that the decision makers may choose the appropriate capital stream (and. therefore. the NPV is compute the AIRRs associated with ten different capital streams. As the reader may note. first illustrated by Eschenbach (1995.69%. the role of the IRR is diminished: it is the capital exogenously determined which uniquely determines the project’s rate of return. In this case. no matter how the capital stream is chosen. but such a solution is just the AIRR corresponding to any capital stream belonging to a Hotelling class. eq. The first five capital streams depict the project as a net borrowing ( five capital streams depict the project as a net investment ( ). the comparison between AIRR and market rate always supplies the correct answer: the project is not worth undertaking. which is equal to 3. whereas the remaining .6) and. by Hazen (2003). later. (7) can be employed to compute the AIRR. Remark 4. Evidently. so they belong to the PV-equivalent: same class and therefore supply the same AIRR. The former requires the solution of the IRR equation. And a Hotelling class is only one class among other infinitely many classes that the analyst may use. ) .1. The fourth capital stream belongs to another Hotelling class and is just the capital .1 implies that Hazen’s decision criterion is a particular case of the AIRR criterion. EXAMPLE Consider the following mineral-extraction project. (6’) or eq. Theorem 4.

04% 0 26.43% 10.88% ) −3.31% 10.5% 4 56.52% −1.862 21.43% −0. .57% 0 −67.5% 0.98% 0 undef.745 −91.826 177.242 10.06% −1.08 11% ( Net investment 4 Period rate 4 Period rate 4 Period rate 4 Period rate 4 Period rate 2 25% 4 75% 3 50% 4.052 26.3 200% 4 0% 8 700% −2 816.105 5% 0 undef.685 10.75 % 3 −71.67 % 4 −18.of the rectangles with base ̅̅̅̅.25 % 0 −228.628 −22.31% −2 31.068 26.098 26.31% −2 −87. 4.8% −0.43% −4 300% −4 100% −2.31% −1 25% 0 10.598 26.75% 1 −70.36 −9.96% −3.43% −1 −50% −2 17.342 26.9% 3.25 AIRR 1.97% 0 undef. 0 −139. and height | ̅ | are equal and correspond to the Table 2.43% 4 4 Period rate 4 Period rate 4 Period rate 2 25% 2.19% 0 undef.34 26.25% 5 141.068 27.05 26.31% −3 25% −3.75 7 −1.25 %% −2.8% 0 156.04% −2.93% 26. 1 150% 4 37. −3.41 58.75 5 0 6 −0.417 10. 5.203 10.25 3 1. def.69% 3.89% 4 37.5 499.69% −1 25% 0 125% −1.5% 6 50% −0.63 39.01% 0 undef. A mineral extraction project (market rate= 5%) Time Cash flows 0 −4 1 3 2 2.43% −2 −31.5 0% −1.5 8 −2.43% 0 −78.31% 2 25% −0.69% 0 undef. 5. project’s time-1 NFV.31% −4 −1.43% 1 62.43% Net borrowing 4 Period rate 16 .2 80% 0 −25% 1 62.5% 1.25 % −3 −6.781 26.1 −35% 4 18.31% −4.5 4 0.87% 3.037 10.9% −6.67 % 4.58 10.43% −10.43% 10.31% 0 125% 9.256 10.5% −2.57% 0 undef.25% −2. 4.34% 0.87 % 5.65 26.25% 2.

69% 4 5. 17 .26.43% and 26 . it signals that the project is not worth undertaking.31%% 10.665 –1.31%) are but two different values taken on by the AIRR function corresponding to two different Hotelling classes.53 –1.145 32 ̅ Figure 2. Mineral extraction example (see Table 2)― any AIRR is a reliable return rate associated with a class of PV-equivalent capital streams: contrasted with the market rate.93% ̅ 5% 3. The project’s IRRs (10.195 –6.87% 27.89% 3.88% –3.43% 9.155 –7.

grow at the market rate: . .1 holds.5. smaller) than the market rate: ∑ (respectively. ∑ ). The reason is that the capitals in In general. the weights being the capitals discounted at the market rate. consider again the project described in Table 2 and focus on This choice implies ( ) . . Rather than computing the weighted arithmetic mean of the period rates. EXAMPLE Consider the cash flow stream . Theorem 5.1 the financial nature of the project is unambiguously revealed by the sign of the first cash flow (the project is a net investment if . The internal return vector is 18 . Using Theorem 5. a net borrowing if ). from or PV- ) a project is profitable if and only if the simple arithmetic mean of its period rates is greater (respectively. This section shows that it is possible to rest on a simple arithmetic mean.1. The simple arithmetic mean The AIRR is a weighted average. the following result holds. the market rate is . let us compute the simple arithmetic mean of the period rates: But ̅ .1. Suppose the capital stream is equivalent to it. For example. suppose . Then for ∑ The same result applies if the capital stream is PV-equivalent to because the AIRR does not depend on Theorem 3. That is. the weighted arithmetic mean is equal to the simple arithmetic mean. If (respectively. the assumption of Theorem 5. . Then. so that ̅ ∑ . If one chooses . is unvaried. as long as .

the project is profitable. While the third component is exogenously given. the first one and the second one depend on a choice upon the decision maker. The IRR of . and the fundamental triplet determines the project NPV: ̅ To economically interpret the above equality. suppose a decision maker has the opportunity of investing in a one-period project NPV of is ( ̅) . which is just ̅ We then maintain that the correct economic yield is just ̅ . the AIRR can. 6. This is confirmed by the NPV. That is. so that project ̅ ( Note that this implies ( ̅ ) ∑ 19 ̅ ) whose NPV is ) is turned into an answer this question. Suppose an investor invests 10 dollars at time 0 and wants to compute the rate of return of those 10 dollars. As we know. Pick equivalent one-period project ( . the IRR cannot . The which evidently coincides with maker to transform project the solution of . The latter may be found by applying the RRR (=8. which is equal to 2. with and ( ̅ ). Rate of return on initial investment ̅ We have shown that the economic analysis of a project depends on the fundamental triplet . bearing the unambiguous meaning of internal rate of return. one may choose such that .35%) to and discounting back by one period.and the simple arithmetic mean of the period rates is Therefore. This means that the use of AIRR enables the decision is into an economically equivalent one-period project.28. The latter may choose any capital stream.

In this case. Note that 11. ̅ ∑ ∑ . which is the only way to compute the rate of return on the capital initially invested. An interpretation of project (1)-(2)) as well. ( ̅ ) . as a one-period project is provided in Hazen (2009. we have ∑ in project . if the investor invests in a one-period project generating a terminal payoff consisting of the cash That is. implicitly determined by the market. the sum of the outlays as the total capital invested. more generally. so making it impossible to consider (let alone ) . the investor may well consider. for the rate of return of those 10 dollars does exist: it is 27. the project NPV is reduced to the economically evident relation “value minus cost”: ⏟ value ⏟ cost Should other outlays occur after the initial one. Such a return rate. Remark 6.51 represents the market value of project 1. which . but the interpretation is bounded by the use of the IRR. Therefore. Therefore.27%. The NPV of is as of time .so that the cash flows which will be generated from time 1 to time T are all compressed back to time 1. which entails an investment of 10 dollars. in such a way. which univocally determines ∑ EXAMPLE Consider a cash flow stream Consider now project is equal to project ’s AIRR ̅ ̅ . the AIRR associated with the fourth capital stream.1%. Note that. 20 . it . Consider the project described in Table 1. As seen. is just the very project disguised as a one-period project: the investor invests 10 and receives the time-1 cash flow along with the market value of project : : we may say that the investor invests his 10 dollars in a project whose economic yield. The market rate is 3% so that . Its unique real-valued IRR is . This is irrelevant to the analyst. ∑ is as if he invested flow ̅ ∑ . and the end-of-period market value represents the rate of return on the dollars invested. is 35. so that using the shortcut in (6’).1. eqs. the traditional IRR does not exist. Therefore. The interpretation is economically interesting: reminding that is the so-called market value of the project as of time . depending on is implicitly determined by the market. .

therefore. respectively. The reason is that the use of a traditional IRR determines the present value of capital stream univocally. The economic and managerial literature have strived to overcome the IRR faults. 7. on its present value) so that the analyst may soundly rank competing projects via their AIRRs. The conceptual and formal shift accomplished by the AIRR approach (let the capital stream be exogenously chosen) unlocks the bounds on the capital stream (and. But while a comparison of AIRR with is sufficient to determine whether an investment is profitable. The rate of return of those 4 dollars is . However. and must be equal: “if the net investments … are very different. The firm with the highest standardized AIRR has the best economic performance.” (Hazen. More precisely.Consider the project described in Table 2. 42). In this case. p. but project ranking with the IRR is so far an unsolved problem. suppose that competing cash flows and are under consideration and let and . But for consistency with NPV to hold. for example.5 dollars. We have and be the investment stream associated with the IRRs. According to the IRR decision criterion. as may be easily checked. the higher a project IRR.5 dollars invested is so that . the higher its rank. one may choose. and the rate of return of those 8. should the analyst consider all the negative outflows as investments. Ranking projects It is well-known in the economic and managerial literature as well as in real-life applications that ranking competing projects by comparing their IRRs clashes with the NPV ranking. which entails an investment of 4 dollars. then it means that the overall investment is equal to 8. allowance for differences in the scale of investment is necessary when comparing investment opportunities. 2003. then comparing the internal rates … will tell us little about the relative desirability of and in present value terms. 21 . We can then use a standardized AIRR for each project. corresponding to .

so. . (8) is derived. . considering that the rates of return ̅ .1. Suppose the benchmark capital is set equal to standardized AIRRs: ̅ . there exists a unique AIRR rate of return for any project . The ranking via the standardized AIRR may be even more fruitfully reframed in terms of residual rate of return ̅ . . at one time. Equation (9) is straightforward. for any (̅ ) (̅ ( ) ) whence eq. Let K be the benchmark capital that is to be the aggregate discounted be used to standardize the profit rates of the different firms. so the ranking is . the residual rates of return are useful for comparing projects with 22 . Then. information about profitability and information about rank. respectively. so that. the NPV ranking is . the AIRRs are easily computed: ̅ . refer to the same benchmark capital . . Let capital of project and let be the benchmark capital that is used to standardize the and any capital rates of return. ̅ ̅ . Consider competing projects .Theorem 7. such that ̅ (̅ ) where ̅ is the AIRR of the -th project. . Applying (8). via shortcut (6’). . The aggregate invested capitals are. denoted by ̅ . ̅ . and such that ( ) ̅ Proof: from Theorem 2. ̅ dollars. (QED) EXAMPLE Consider the following projects: and let respectively. Suppose the associated interim capitals are. that would result from employing . The net present values are . one gets the . which is just the NPV ranking (see also Figure 3). (see Table 3).1. Also. The latter provides.

̅ 19.1% 100 project 1 project 2 project 3 Figure 3.different risks.7% 5% 1. the result holds for every the graph for ).1. for all the problems of IRR reverberate on the incremental project: in particular. Note that the incremental IRR is sometimes evoked to overcome the IRR problems (it is just Fisher’s rate of return over cost mentioned in footnote 1 above). the greater the value created for the investor. (We omit Remark 7. it does give problems with the IRR approach. in this case. Project ranking with the AIRR (see Table 3). while this method does not give any problem with the AIRR methodology. However. the higher the project rank. in presence of two projects one may consider the incremental project obtained by subtracting the cash flows of one project from the cash flows of the other project. 2011). each project has its own cost of capital residual rate of return ̅ so that the higher the . the incremental IRR may be not unique or may not even exist. the iterated application of the incremental method provides the same ranking of the NPV.3% 14. Evidently. Note also that project ranking may also be inferred graphically: Figure 3 shows that an inspection of the graphs of the return 23 . The project ranking and the choice between mutually exclusive projects may be coped with by using the incremental method as well. and apply the acceptability criterion to the incremental project (see Magni. For example. The greater the AIRR. If more than two projects are under examination. .

As for (viii). note that the NPV is being .3. Using AIRR. for the IRR equation is . Therefore. economists and finance theorists believe that an arbitrage strategy has no rate of return. The IRR does not exist. As for (vii). While the IRR criterion is not capable of handling variable market rates.2. ̅ and the capital invested is naturally selected as . the AIRR theory correctly individuates the loss of 100% of the capital. The NPV is . in (viii) the investor earns 100% of the capital borrowed. where is the ̅ Searching for a Chisini mean ̅ of the market rates. ̅ means that the investor has undertaken a borrowing with interest rate equal to (vii) and (viii) are symmetric: in (vii) the investor loses 100% of the capital invested. one solves ∑ getting to ̅ ∑ ∑ ̅ replacing ( ̅ ) All results proved in the paper hold with ̅ 24 . which has no solution. Remark 7. from (6’). the higher the ranking (we remind that the graphs of the return functions of different projects never intersect). Therefore. It is noteworthy that the IRR problems (vii) and (viii). mentioned in the Introduction. Yet. Therefore. Note that investor is not reimbursed. nor is paid any interest. Given that there is no other cash flow.functions provides the correct ranking. our approach is easily generalized. ∑ ̅ ̅ ] and ∑ ̅ . it is rather obvious that the investor loses 100% of the capital invested. for the higher the graph of the return function. The NPV of a project will be is the market rate holding in the period [ discount factor. have natural economic interpretations and are easily solved within the AIRR theory. which . the capital owed by the . Suppose that the cash-flow vector is with dollars. whence. Remark 7. consider the project with . the arbitrage strategy is interpretable as a borrowing of .

considering that all projects s refer to the same aggregate capital .1. (QED) EXAMPLE Suppose the manager of a firm is endowed by the shareholders with additional equity to be invested in some business.89% 2. Consider competing projects equal initial cash flow with respective length and Suppose that the capital stream for each project is PV-equivalent to . where .1. . then. . the AIRR is equal to the simple arithmetic mean. Proof: If is PV-equivalent to for all . Then. The internal return vectors are. which is the case of a decision maker who is endowed with a capital to be invested in some alternative. For simplicity. Suppose he has the opportunity of employing the capital in three economic activities: . The market rate is so that . the ranking of the projects via the arithmetic mean of the period rates is equivalent to the NPV ranking. Let us begin with projects with equal initial outflow (or inflow).1. which is just with . The simple arithmetic means are: project project project 6. 25 . respectively. The thesis follows from Theorem 7. The simple arithmetic mean in project ranking In this section we set the conditions for the use of a simple arithmetic mean in project ranking. Theorem 8.72% 9.8. . we pick the same capital stream for all projects: .38%. owing to Theorem 5.

which is the same as the NPV ranking. if some projects have the same initial cash is the null vector).7 EXAMPLE Consider the following three projects: and let 5% be the market rate.The ranking is then . It is straightforward to compute the economic yields (simple arithmetic means): 7 Note that the theorem includes those cases where (i. . Consider. Project is a mute . for example. for all the projects. We then apply Theorem 6.. For example.1 may be applied to . with different initial cash flows. which implies The initial outlay of and is 100. whereas the initial outlay of is only 10. the project starts at time ) 26 .2. The latter implies following mute operations: . Consider competing projects with different initial cash flows. We have then proved the . let operation: for any Thus. so we use the . Pick any project . We exploit Let us now focus on a bundle of projects the fact that the NPV of a project does not change if the project is virtually integrated with a value-neutral investment. so one may always use for economic analysis purposes.3 to the integrated projects . then for all (obviously. Using the appropriate (fictitious) mute operations in order to harmonize the initial cash flows. Then. rather than . Theorem 8. such that the integrated project has the integrated project vector and consider the mute operation the same initial cash flow as flow as . the ranking via the simple arithmetic means coincides with the NPV ranking. But the latter are financially equivalent to following Theorem 8.e.

the rate of return essentially depends on capital. the rate of return is thought of as a relative metric affected by cash flows: in general. Boulding (1935) and Keynes (1936). the rate of return is a function of cash flows alone and the IRR equation is the formal clothing of the dependence of rate of return on cash flows. a 10% rate of return means that for each dollar invested the investor receives 0. According to the usual interpretation. in association with the cost of capital . the rate of return increases. but that 10% is believed to be independent of the absolute amount of capital injected into the project. correctly 27 . A rate of return is necessarily associated (explicitly or implicitly) with a capital. these rates make up a return function (see Figure 1). viceversa. Mathematically. a rate of return always refers to the capital of a project. However.89% 2. the project ranking is 6. Scientific and applicative implications of the AIRR theory: The paradigm shift In economic sciences. which means that there are infinitely many rates of return associated with the project.92%. and. for any fixed vector of cash flows. but to solve a cash-flow-based equation. This implies a fundamental economic truth: there is no biunivocal relation between a cash-flow vector and a rate of return. which is based upon these premises. where capital is dismissed in favor of cash flows. it is just the dismissal of capital in favor of cash flows which gives rise to the problems that have been vexing scholars for eighty years. The previous sections have shown that such vexing problems disappear if the IRR equation is dismissed and the capital is given back its major role in determining the rate of return of an economic activity. if cash flows are increased (and the NPV function is monotonically decreasing). So. as well as Fisher (1930). That is. The investor is not required to explicitly determine the capital of the project. have contributed to such a belief by defining a rate of return on the basis of a polynomial equation. the same as the NPV ranking.1 dollars. the greater the rate of return. the idea is that. according to this view.72% 3. the choice of the capital may be arbitrary: any capital determine a rate which. the greater the cash flows. there correspond infinitely many capital streams that are compatible with that vector.project project project Then. 9. As a matter of fact. the rate of return of the project does not change if cash flows are fixed. . whatever the capital. not to the cash flows of a project.

̅ is. and this is just a consequence of the fact that the notion of rate of return is not associated with cash flows. that the economic profitability of a firm is to be determined. And these capital values depend on the economic domain the investor is immersed in. At a terminal date. hence.. a point lying on the return function’s graph. even if they turned out to share the same cash-flow vector . considering the industrial project. expenses. in general. in accounting terms.signals profitability. The pair ̅ is a point lying on the graph of the return function. as a third example. Suppose a fund manager receives an amount of money by a client for investment. the aggregate . The pair graph of the return function. If the economic situation is different. But. economically. the choice of capital must be an appropriate one: the rate of return of a project is the rate associated with the capital stream that describes meaningful values of economic resources. one point lying on the As a result. In particular. Such a book-value- then individuated by the AIRR associated with book value: ̅ based rate is an average “Return On Assets”. again. principal payments of debt etc. their rates of return would not coincide. 28 . interest payments etc. The accounting data inform about the book value of the firm’s assets and about the accounting operating profit. 8 Suppose now. The pair is. the determination of the capital (and of the rate of return) changes accordingly. In this situation. and the economic profitability of the firm is ̅ . the investment fund and the firm. to different rates of return which depend on the economic milieu in which the investment’s cash flows are generated. so the aggregate capital invested . For example. the ingredients of the rate of return are the estimated incomes derived from estimation of sales. the same vector of cash flows gives rise. and the estimated capitals derived from estimation of net working capital. depreciation of assets. again. the rate of return of the project is obtained as the ratio of aggregate income to aggregate capital: ̅ ̅ . on the basis of historic accounting data. which we denote by is ̅ . a market-value-based AIRR. if an accept/reject decision problem refers to an industrial project. is be the vector of the assets’ book values. 8 See Altshuler and Magni (2012) for the use of market-value-based AIRR in real estate. the investment is liquidated. The estimation of the capitals univocally determines the aggregate capital invested in the project and. The client periodically injects further capital into the fund managed by the investment manager and/or withdraw some amount of money from it. it is evident that the capital invested in each period is the market value of the fund. The rate of return is then ̅ ̅ . Letting capital invested.

if one does not determine a capital. In other words. And. the ratio of income by overall capital supplies back the IRR. eq. it must be formally defined as a ratio.but with the capital invested. Far from being paradoxical. with those very cash flows. once fixed the appropriate capitals. that ratio is obviously income divided by capital (i. this fact has contributed to draw attention away from the IRR-implied capital. at a deep linguistic inspection. for a rate is “a quantity. buried under the obscure sands of the IRR equation. the IRR is indeed obtained. (7) above). The two things here involved are “income” and “capital”. for the same NPV). As for the IRR. or degree) between two things” (Webster’s Third New International Dictionary). then it is natural to expect different rates of return: the rate of return is a concept based on economic notions (income and capital). because. That “per unit of something else” is the key point: if a rate of return is to be a degree of something per unit of something else. For example. so. as seen. By picking the (present value of the) interest payments and dividing it by the (present value of the) principals outstanding. if the borrowing rate is constant.. As such.e. it is itself associated with a specific capital. in actual facts. Although the IRR equation only displays cash flows. And the “fixed relation” a rate of return discloses is. the term “rate” literally means “a fixed relation (as of quantity. in our case. the IRR equation internally (i. and so doing we uncover hidden features of the rate-ofreturn notion which have been lying. the stream of principals outstanding displayed in the amortization schedule will be different. considering a loan.e. not on cash. for many decades since 1930. We then restore the primitive. This paper just sticks with this correct meaning of the word “rate”. a ratio. so that the same arithmetic operation (aggregate interest divided by aggregate principal outstanding) will 29 .e. But if that very loan. one may not determine a rate of return. this result is natural.. and. implicitly) devises its own fictitious capitals. has varying interest rates. natural meaning of “rate of return”. and if different capitals are determined for the same cashflow vector (i. the condition NPV=0 automatically imposes constraints on the class of capital streams (see Hotelling class in section 4). amount. or degree of something measured per unit of something else” (Webster’s Third New International Dictionary). then the true capital stream is given by the stream of principals outstanding (residual debts) displayed in the amortization schedule. formally. the IRR is devoid of economic meaning barring the unlikely case where. an amount. capitals are built in the very equation and therefore hidden behind that equation.

decisions on grants of loans to investors based on rates of return of past investments and. 30 . not even if it is unique. The true. any economic analysis or decision involving the use of the rate of return. for a project. ranking of fund managers’ performances. combined with the cost of capital. not an “ad hoc” procedure which artificially forces the IRR-implied capital to be consistent with the IRR. incentive compensation of managers based on rates of return. such as economic analysis made by policy regulators and auditors. Put it differently: the cardinal value of the rate of return is at stake. it is evident that the evaluator does not want any real number. if one wants to compute a correct rate of return. and that pair. will invariantly produce the NPV. so the determination of the correct capital is essential. tax policies based on rates of return or on residual income. In general. a fortiori. the invested capital is found as But has no empirical referents. So. economically. unrelated with the true capitals invested in the economic activity. the IRR is an “ad hoc” rate of return: its associated capital is obtained in an automatic way by forcing the IRR to be consistent with the NPV: once computed the IRR. its determination is is an empirical matter. it is mandatory in all those cases where a rate of return is used in other kinds of economic analyses or decisions. the IRR is not the correct rate of return. the evaluator needs compute a real number which correctly captures the actual economy of the investment. for the automatic procedure distorts the true capital stream by cooking up its (ambiguous and) fictitious interim capitals. As seen.generate a different rate of return. In general. and. in general. a real number which can be interpreted as the return per unit of capital actually invested in the project. the use of a rate of return as opposed to another one does change the analysis or decision. correct capital must be explicitly individuated. mathematically speaking. it does not correspond to anything one might recognize as values of economic resources invested in the project. This correct rate of return is needed in case of accept/reject decision or project ranking. so that one may not rest on any real number. whether one uses an IRR or any other real number is irrelevant: any real number is associated with a capital. In such relevant cases. it is not even univocally associated with the assumption of constant rate of return. But.

The capital in a loan is the principal outstanding. it is by no means the unique information one may be willing to draw from a project. while the information about return on aggregate capital is essential. The return per unit of total disbursement is obtained by picking capital is obtained by picking ( ) . It is true that. the capital in security or in a financial portfolio is the market value. An evaluator might be willing to draw information about the return on the initial capital invested. one legitimately may be willing to measure the return that those 100 dollars. So. To draw other kinds of information.The results obtained in this paper call for a paradigm shift in the theoretical realm and in real-life applications: the rate of return is essentially a relative measure. But. once fixed the capital stream. The determination of the latter is needed only if the information required is return on aggregate capital. The explicit account of capital opens a new way of thinking about uniqueness of a rate of return in the following sense. And. which means that two projects with equal cash flows will in general have different rates of return. invested at the outset. not relative to cash flows. have generated (see section 6). And so on: the 31 . as seen. But the evaluator might as well be willing to measure the return on the average capital as well. the capital in a firm is the book value. it is also true that one may use the computational shortcut ̅ stream and explicitly choose one value of without explicitly determining a capital is constant across the economic . if one invests 100 dollars at time 0 and that investment generates a stream of cash flows. After all. one just has to exogenously fix a value for ̅ The return per unit of initial capital is obtained by picking ∑ in . It is the evaluator that subjectively decides which piece(s) of information he is willing to retrieve from the notion of rate of return. or the return on the total disbursement made by the investor. the associated rate of return exists and is unique. viceversa. In other terms. The cash-flow vector is uninformative about the rate of return if a determination of capital is not provided. even if cash flows are equal. based on a different capital. the equality ̅ (which is just (6’)) implies that the same rate of return will be generated by economic activities with different cash flows and different NPVs if the ratio activities. different economic activities will generate different rates of return. relative to the capital invested. The return on average (or some other kind of average). but aggregate capital is only one possible choice for . the capital in an industrial project is the estimated value of the asset involved in the operating activities.

Just as an example. then. is a sophisticated procedure for selecting one point on the return function’s graph. The same holds for the long-praised papers by Teichroew. Therefore. interpreted in the light of our results. engineers. Their proposal consists of picking the cost of capital as the borrowing rate and solving for the implicit lending rate. But their solution is. 32 . of the netpresent-value functions of the truncated projects. Arrow and Levhari (1969) redefine the rate of return in a rather complex and sophisticated way: they consider all the subprojects that are obtained from the investment under consideration by truncating it at each date. letting ̅ be Arrow-Levhari’s rate of return. only a value taken on by the project’s return function. finance theorists to provide a 9 Their objective was to solve the IRR problems and provide a rate of return which exists and is unique. it is noteworthy that the new theory is robust enough to encompass all possible definitions of rates of return as real numbers. Robichek and Montalbano (1965a. in particular. And it comes as no surprise that the nonuniqueness of rate of return does not imply that the meaning of rate of return is ambiguous. they define the maximum present value as the maximum.evaluator may pick any capital desired to obtain the answer of any question about return per unit of capital invested. with an associated capital which is a fictitious capital unrelated with the reality of the economic situation under consideration. their proposal. but that additional information is provided by different choices of . it is artificially created and serves the mere purpose of finding a unique generalized internal rate of return (see also Gronchi. 1984). It comes then as no surprise that a project has several different rates of return which answer different questions. Arrow-Levhari’s rate of return is nothing but an AIRR associated with a particular aggregate capital . 1965b). for the IRR equation only provides one type of information: the return on an aggregate capital. This can be said of every proposal appeared in the literature so far: all past efforts by economists. where the authors define a recurrence equation for the capital on the basis of two rates. mathematicians. for each rate . from this point of view. and. Therefore. It is evident that. it does not provide information on the return on initial investment or average capital or total disbursement. Eventually. the IRR collapses. Finally. the IRR is not capable of giving any other information. again. we may write ̅ capital which generates such a rate: ̅ and solve for to find the . a borrowing rate and a lending rate.9 But. they define the (internal) rate of return of the original project as the zero of the maximum present value function.

The RRR. intriguingly. managers. 7). Weston and Copeland 1988. whereby the correct rate of return is identified as the ratio of the aggregate income generated by the project to the aggregate capital invested in the project. This paper presents a new theory of rate of return. If the evaluator is willing to draw information about the return per unit of the overall capital invested in the project. at one time. practitioners have long since recognized that the NPV criterion is a theoretically sound decision criterion for capital budgeting in most circumstances (e. managers. MacMinn 2005). Dixit and Pindyck. p. And. Concluding remarks Scholars. and then say that the rule ‘invest if NPV is positive’ holds once this correction has been made’’ (Dixit and Pindyck 1994. Brealey and Myers 2000. which is defined as the difference between AIRR and market rate: this index signals. 1994. which can even used for projects with different riskiness. the choice of the capital stream depends upon the economic situation in which the investment is undertaken. As a result. where the set of alternatives is inclusive of the options implicit in the project: ‘‘one can always redefine NPV by subtracting from the conventional calculation the opportunity cost of exercising the option to invest. practitioners often find it useful (or are explicitly required) to supply a performance measure in terms of rates rather than present values. the capital stream selected in a loan contract will be The real options approach is but a sophisticated version of the traditional NPV model. 10 33 .g. An investment (borrowing) is worth undertaking if and only the AIRR is greater (smaller) than the market rate and the AIRR ranking is the same as the NPV ranking. analysts. So. Fisher 1930. it will necessarily be a particular case of AIRR (as long as the definition individuates a single real number as a rate of return). One may also equivalently use the residual rate of return (RRR). 10 However. each implicitly associated with a well-defined capital which has not to do with the true capital invested in the project. any possible past and future definition of rate of return as a real number is chained in the AIRR model. and even real options may be framed in terms of an ‘expanded’ NPV.reliable definition of rate of return boil down to being particular cases of AIRR. if any other definition of rate of return will be given in the future. Such a rate is called Average Internal Rate of Return (AIRR) and may be framed as a mean of one-period return rates derived from the project’s capital streams. desirability of a project and its rank among other competing projects. is a perfect substitute of the NPV and represents the excess return on one unit of invested capital.

but on an explicit determination of capital. to determine the return on the aggregate capital invested without detailed information about the actual investment. contrary to what commonly believed. a rate of return does not depend on cash flows. but. In these cases. The return per unit of aggregate invested capital is linked to the milieu the economic activity under consideration is immersed in. the assumption of capital increasing at a constant rate (and. even if the cash flows are equal. evidently. The role of the IRR is evidently diminished. therefore. This means that it is not possible to define the return on the aggregate capital invested in an economic activity without a thorough inspection of the economic features of that activity: to different economic situations there will correspond different rates of return. a constant-interest-rate loan).given by the principals outstanding. on the total disbursement. Just for this reason. But.g. the estimated capitals will be used. the evaluator may fix his own preferred notion of capital in order to compute the return per unit of that very capital. if a security or a financial portfolio is under analysis. the market values will be used. the information on the overall capital invested is only one piece of information. Uniqueness of a rate of return takes on a different meaning: the correct rate of return is not unique. if a real asset investment is at issue. it only measures a return on an aggregate capital. in all those situations where the estimation of the capitals invested in the project is not possible or the cost of the estimation is deemed excessive. above all. but it is by no means nullified. In other words: it is not possible. the computation of the IRR) is acceptable. on the average capital etc. theoretically. for there are several different correct rates of return which take different notions of capital into 34 . the marketplace values of the asset will be considered. the aggregate capital is not even the correct aggregate capital: it is based on fictitious interim capitals that have nothing do with the correct capitals invested in the project. The long-praised IRR cannot measure the return on initial investment nor the return on total disbursement. It may still be used in a number of situations: not only in those situations where the rate of return is constant by definition (e. And the determination of capital bears relation to the issue of the uniqueness as well. it is a particular case of AIRR where the aggregate capital is automatically produced. The new theory purported in this paper calls for a paradigm shift: the whole conceptual building of the notion of rate of return and its theoretical and applicative role should be radically revised. and so on. That is. The hub lies in the fact that. if an industrial project is investigated. The evaluator may ask for the return on the initial capital.

In this sense. operating). A natural sequel of this paper is Magni C. but it is capital which determines a rate of return. the notion of capital is not unique. Available at SSRN: <http://ssrn. total disbursement. total. In a nutshell: it is cash flow which drives wealth creation.com/abstract=2172965>. but a deeper economic understanding of the investment under consideration. but the (non)uniqueness of the rate of return is not a problem at all. The Internal-Rate-of-Return approach and the AIRR paradigm: A refutation and a corroboration. Addendum (December 3th 2012).A.consideration: aggregate capital (equity. The Engineering Economist 2013. The paper presents a compendium of eighteen fallacies of the IRR approach on the basis of which the IRR approach is refuted and the AIRR paradigm is corroborated (the IRR is retrieved as a particular case of AIRR). initial capital. so rate of return is not unique. average capital etc. 35 . nonuniqueness does not mean ambiguity about economic profitability. scholars have spent eighty years on attempting to solve the problem of uniqueness of IRR.. 2013. The new theory of rate of return illustrated in this paper restores the capital to its full role of fundamental driver of an investment’s rate of return.

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