Management Accounting-Decision Management: The Internal Rate of Return May Be a Flawed Investment Appraisal Method, Writes Grahame Steven, but There Is a Small Modification That Can Help

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It seems safe to assume that businesses have always made formal evaluations of potential investments, particularly large ones, but that's not the case. There is evidence from the late 19th century that many firms simply used a mixture of gut feel and payback. Big investments in machinery were also often written off to the P&L when they were incurred, not put on the balance sheet and depreciated. Why they did this isn't entirely clear. Perhaps it was because most firms had only one line of business. But the simple approach to investment appraisal was to change with the advent of more complex companies at the turn of the 20th century.

DuPont was one of the first to be created when two cousins bought out their family's interests in a number of firms in the US. The company was a more complex organisation than its contemporaries because it performed a wide range of functions--production, distribution, selling etc--and sold different products to different markets. It had unwittingly created a business model that would be replicated around the world.

DuPont quickly realised that it needed mechanisms to evaluate its diverse interests and decide how best to allocate money to competing projects. The big breakthrough it made was to grasp the importance of measuring the return of its various businesses. Investments in fixed assets were no longer written off to operating expenses; they were placed on the balance sheet and depreciated. DuPont then used return on investment (ROI) to evaluate divisional performance and accounting rate of return (ARR), which is based on ROI, for investment appraisal. Many other firms soon adopted these methods.

The use of ARR for investment appraisal started to be questioned in the forties, but the dominant role played by DuPont in the development of management accounting techniques ensured that the method was still commonly used in the sixties even though it had been discredited. Even DuPont dropped it in the seventies. So what replaced ARR?

The use of discounted cash flow techniques to evaluate future earnings can be traced all the way back to the sixteenth century. But the first recorded interest in the use of such techniques for investment appraisal didn't occur until the end of the nineteenth century when Arthur Mellen Wellington, a civil engineer, advocated the use of present value. Unfortunately, his pioneering work attracted little interest and the business world had to wait more than 50 years for the development of modern investment appraisal techniques: internal rate of return (IRR) and net present value (NPV).

The first recorded use of IRR was by another engineer, John Gregory, at Atlantic Refining in 1946 to evaluate the purchase of a ship. He developed the method because he considered his company's existing approach unreliable since it didn't use cash flows. Standard Oil soon followed Atlantic Refining's lead and some influential commentators also championed the use of IRR for investment appraisal, despite the fact that weaknesses had already been identified in the technique.

IRR is the discount rate that produces a zero NPV for a project's cash flows. A project should be accepted if the cost of capital is less than the project's IRR and rejected if it is greater. Table 1 on page 50 contains an example that shows how to derive IRR using a spreadsheet model. While the interpolation method can be used to find IRR, numerous iterations must be done to produce an accurate figure. The calculation assumes that money earned from a potential investment will be reinvested at the project's IRR. Table 2 uses the IRR calculated in table 1 to illustrate this point by calculating what project cash flows would be worth at the end of the project if they were reinvested at its IRR. But is this a realistic assumption, particularly if a project has a high potential return?

IRR has also been criticised because it doesn't always correctly evaluate mutually exclusive projects or ensure the best allocation of resources when capital rationing occurs. …