Results of a recent survey of over 100 exploration production, and transmission companies operating in the Rocky Mountain Region indicate that the internal rate of return (IRR) is extremely popular as an economic evaluation criterion. popular as an economic evaluation criterion. However, there still remains, in the views of many authors and evaluators, a question concerning the validity of the IRR calculation. The validity question involves the calculation procedure and whether a rate of reinvestment of incomes is implied or not. Some feel that inherent in the calculation procedure is a reinvestment of incomes at the computed IRR, while others argue that there is no reinvestment implied and that it doesn't matter what is done with the incomes. Because of the reinvestment question and other complications of the IRR calculation, some individuals have suggested that other evaluation criteria be used. This paper contains two parts. The first part presents a review of a few of the evaluation presents a review of a few of the evaluation criteria used in the industry, and the results of a recent survey concerning those criteria. The second part of the paper will address the reinvestment question and attempt to prove that the IRR calculation procedure does indeed imply reinvestment of incomes at the IRR.
Introduction
The subject matter of this paper is not new. Engineers have been concerned for years about the evaluation of projects and the efficient allocation of available capital. Each engineer faced with a decision between two or more investment alternatives uses at least one evaluation criterion that will aid in the decision making process. The criteria or profitability measures are chosen either by the engineer or by the engineer's employer. Thompson and Wright provide the following list of characteristics of an ideal criterion. It should:Be consistent with corporate goals.Be easy to understand and apply.Permit cost-effective decision making.Provide a quantitative measure for acceptance or rejection.Permit alternatives to be compared and ranked.Incorporate the time value of money.
There are very few evaluators who would claim that the ideal criterion has been identified and so usually more than one is used in the decision making process. One of the more popular techniques is the discounted cash flow rate of return (DCFROR) calculation introduced by Dean to the petroleum industry in 1954. The DCFROR is known by several other names including the internal rate of return (IRR). During the remainder of the paper the nomenclature IRR will be used. An argument over the validity of the IRR as an evaluation criterion has been conducted in the literature and in textbooks in recent years. The argument centers around the question whether there is implied in the IRR calculation procedure a reinvestment of incomes or not. The primary purpose of this paper is to provide information to aid in the resolution of provide information to aid in the resolution of this difference of opinion. The importance that the IRR calculation has taken on in the evaluation of projects would seem to warrant a clarification of this issue. The paper also presents a review of the most popular profitability measures. The strengths and popular profitability measures. The strengths and weaknesses of each criterion are discussed. The results of a survey on the use of these criteria by companies operating in the Rocky Mountain Region are also presented. The paper is organized into two separate parts. The first part contains the review of the parts. The first part contains the review of the evaluation criteria and the results of the survey. Conclusions of the first part are presented before the discussion of the second part. The second part addresses the reinvestment question and the validity of the IRR as an evaluation criterion.
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