USE AVERAGE INTERNAL RATE OF RETURN (AIRR) AND NOT INTERNAL RATE OF RETURN (IRR) PART 3

Dear Karnen,

Please find enclosed my latest paper on AIRR, recently published in the Journal of Mathematical Economics.   Section 8, specifically devoted to practitioners, shows three different examples, including HomeNet’s example from Berk and DeMarzo’s textbook.

I welcome your comments and thank you very much for your attention

Best regards

Carlo Alberto Magni, Associate Professor
Department of Economics, University of Modena and Reggio Emilia
 
The Engineering Economist – Area Editor

I forward Prof. C.A. Magni’s above paper to Prof. Peter DeMarzo to seek his comments.

Personally, I see Magni’s paper on AIRR is quite comprehensive and convincing.

Hi Prof. Peter DeMarzo,I sent herewith one article written by Prof. C.A. Magni, in which he
shows AIRR implementation by using the HomeNet’s example taken from
your book (see page 70 and 71).Though of course, we could just jump to NPV, yet, by putting something
into “rate of return” (in %) it is much easier to get the point across
to the other side of the table in many project analysis discussions.

It works for somebody without or with short finance course in the
backdrop.Though I see a lot of Corporate Finance traditional textbooks
explaining away on how to get the IRR, but it is not really touching
the bone of this IRR. One article back in 1976 by C.B. Akerson, I
guess, appropriately quite well in giving us a better idea about what
this IRR is. From this paper, IRR seems this concept is built around
the savings bank account analysis, in which the intermediate value is
pretty clear to forecast.Akerson, C.B., The Internal Rate Of Return in Real Estate Investments,

A Research Monograph, Prepared for the American Society of Real Estate
Counselors, 1976. Looking forward to hearing your opinion on this.

Thanks

Karnen

Prof. Peter DeMarzo:

 

Hi Karnen,

I have looked briefly at this but still remain unconvinced that it is very practical.  Like IRR, it does not improve upon NPV.  And worse, it tempts users to rank projects by their returns – don’t you agree?

Ignacio Velez-Pareja

Listen, I don’t like rates of returns, in general. Imagine this: you surely calculate THE internal rate of return of  one project. However, if you do correctly the valuation, as you know, you have DIFFERENT discount rates for each period. N discount rates. What do you do with ONE IRR and N discount rates? Which discount rate is the one you choose to compare IRR with it?

 

Carlo Alberto Magni, Associate Professor

Department of Economics, University of Modena and Reggio Emilia
viale Berengario 51, 41121 Modena

Dear Karnen,

Prof. DeMarzo‘s answer is in line with what he wrote to you in Dec 2015. He seems to dislike rates of return and prefer NPV.

I agree with him that NPV is the gold standard, but practitioners feel the rate-of-return notion is more intuitive, so it is our duty as scholars to provide an NPV-consistent measure of economic efficiency in relative terms

I sometimes work with practitioners and m always requested to provide an alternative to IRR which can be compatible with the NPV notion. AIRR is one such measure.

As for the idea that AIRR “tempts users to rank projects by their returns” my latest paper indeed shows that practitioners may use AIRR for ranking projects, getting the same result as the NPV ranking. You can download the paper:

Chisini Means and Rational Decision Making: Equivalence of Investment Criteria (by Carlo Alberto Magni, University of Modena and Reggio Emilia – Department of Economics; Piero Veronese, Bocconi University – Department of Decision Sciences; Rebecca Graziani, Bocconi University – Department of Policy Analysis and Public Management) Date written September 14, 2017

 

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3037103

, where I presnet two different-but-equivalent method.

This is not to say that ranking projects with rates of return is recommended in general. It is only to say that (standardized) rates of return may be reliably employed for ranking projects. Evidently, care is needed to handle these cases and, needless to say, ranking with IRR is NPV-inconsistent.

I am currently working on a monograph presenting an integrated approach to proejct appraisal. Its title is “Project appraisal and the logic of valuation. Linking finance, acconting, and engineering economics” and all these issues will be investigated.

Best regards

Carlo Alberto
Posted in ARTICLES & VIDEOS, CAPITAL BUDGETING.

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