The Internal Rate of Return and the Reinvestment Fallacy

Keane, Simon M.

doi:10.1111/j.1467-6281.1979.tb00073.x

Cited by 14 publications

(3 citation statements)

References 2 publications

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“…Specifically, does the IRR approach implicitly assume the intermediate cash flows generated by a capital investment project are reinvested at a rate equal to the IRR? Even though the verdict is leaning toward no reinvestment rate assumption in the IRR method (Alchian, 1955; Doenges, 1972; Dudley, 1972; Keane, 1979; Meyer, 1979; Bierman and Smidt, 1980; Dorfman, 1981; Nicol, 1981; Beidleman, 1984; Lohmann, 1988; McDaniel et al , 1988; Crean, 1989, 2005; Hartley, 1990; Plath and Kennedy, 1994; Johnston et al , 2002; Karathanassis, 2004; Eagle et al , 2008; Rich and Rose, 2014), a multitude of textbook authors and researchers are still for the reinvestment rate assumption being embedded in the IRR calculation (Chang and Swales, 1999; Block and Hirt, 2008; Keown et al , 2008; Gallagher, 2010; Graham et al , 2010; Gitman and Zutter, 2012; Moyer et al , 2012; Brigham and Houston, 2013; Balyeat and Cagle, 2015). Dudley (1972, p. 908) argues that the origin of the controversy can be traced back to Renshaw’s (1957, p. 193) “inaccurate parenthetical summary” of Solomon’s (1956, p. 127) remark on the ranking of mutually exclusive projects.…”

Section: Literature Reviewmentioning

confidence: 99%

Purchasing power return, a new paradigm of capital investment appraisal

DeBoeuf

Lee

Johnson

et al. 2018

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Purpose The purpose of this paper is to contribute to financial managers’ capital budgeting decision-making processes by proposing a new paradigm of capital investment appraisal. The expected return, required return structure of the proposed purchasing power return (PPR) methodology eliminates the many flaws associated with the competing internal rate of return (IRR) and modified IRR (MIRR) techniques. Design/methodology/approach The authors provide a new framework for examining long-term investment projects through a percentage return prism. Unlike that of IRR and MIRR, mathematical consistency with net present value (NPV) is a design requirement. Findings PPR eliminates the many flaws found in the IRR and MIRR methodologies, is mathematically consistent with NPV, and identifies positive-NPV investments forecasted to reduce the company’s purchasing power. These projects are acceptable under NPV, but flagged for additional review and potential rejection. Created to examine projects on a percentage return basis, PPR employs market-based inflation rates to convert all cash flows into constant purchasing power units of measure. From these units, an expected real return is estimated and compared to the project’s inflation-adjusted required return, resulting in an accept/reject decision consistent with that of NPV. Originality/value The proposed PPR is a new paradigm of capital investment appraisal that eliminates the many problems found in the IRR and MIRR techniques, is mathematically consistent with the NPV method, and helps financial decision makers examine investment projects on an expected percentage return basis. PPR also flags for further review projects expected to actually reduce the company’s purchasing power.

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Section: Literature Reviewmentioning

confidence: 99%

Purchasing power return, a new paradigm of capital investment appraisal

DeBoeuf

Lee

Johnson

et al. 2018

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“…Even with this change, IRR still overestimates the implied rate of return by 6.2% per annum. Dudley (1972) identified a common misconception about the IRR known as the reinvestment fallacy (see also Keane, 1979). The misconception is to believe that the IRR implicitly assumes that project inflows will be reinvested at the IRR rate.…”

Section: Derivation and Interpretationmentioning

confidence: 99%

What is an Investment Project's Implied Rate of Return?

Bornholt

2016

Abacus

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How to measure a project's implied rate of return has long been an unresolved problem, except for some special cases. This paper derives return on present cost (ROPC) as the correct measure of an investment project's implied rate of return. The IRR is a biased measure except for projects classified as simple projects, and this bias is likely to be substantial in many real-world applications. Thus while net present values should be used to determine whether to accept/reject projects, I recommend that analysts use ROPC in place of the IRR as a measure of a project's true rate of return.

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“…Their methodical solutions are also varied (e.g. Dudley, 1972;Carlson et al, 1974;Keane, 1979;Lohmann, 1988;Johnston et al, 2002;Crean, 2005;Rich and Rose, 2014). In a great number of studies in this topic, many unclear conditions, categories and phrases can be found.…”

Section: The Reinvestment Rate Assumptionsmentioning

confidence: 99%

Problematic methodological questions of investment project evaluation

Illés¹

2017

Management and Organization: Concepts, Tools and Applications

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SummaryThere are some scientific questions related to the NPV and IRR which have not been worked up. From these issues, this paper discusses the economic content of the two categories and the questions of usability for project evaluation and ranking. The main research methods are methodological analysis, model editing and examination of the mathematical formulas. The paper proves that the NPV is the discounted amount of the surplus profit generated above the profit requirement, and points out, that content band of the real reinvestment rate assumption is fundamentally different from everything that can be found about this in the literature. Because of the NPVs are not comparable, the paper systematically eliminates the distortion effects. Thus, the NPV transforms into a special kind of rate, namely, the difference between the factual rate and the required rate of return. This NPV rate (with equal required rates of return) gives the same ranking list as the IRR. The aggregate capital needs is a new conception and gives a new viewpoint to analysis of investment projects evaluation. The paper defines the special content of aggregate capital needs and compiles an index number for it.

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The Internal Rate of Return and the Reinvestment Fallacy

Cited by 14 publications

References 2 publications

Purchasing power return, a new paradigm of capital investment appraisal

Purchasing power return, a new paradigm of capital investment appraisal

What is an Investment Project's Implied Rate of Return?

Problematic methodological questions of investment project evaluation

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