Education Briefing: A review of problematic investment selection issues associated with IRR and NPV benchmarks
| Date | 13 June 2024 |
| Pages | 604-613 |
| DOI | https://doi.org/10.1108/JPIF-04-2024-0051 |
| Published date | 13 June 2024 |
| Author | James E. Larsen |
Education Briefing: A review of
problematic investment selection
issues associated with IRR and
NPV benchmarks
James E. Larsen
Department of Finance and Financial Services, Wright State University,
Dayton, Ohio, USA
Abstract
Purpose –The aim of this Education Briefing is to comment on the problematic issues that sometimes arise
when using the internal rate of return (IRR) and/or the net present value (NPV) as a measure of expected
investment performance. The briefing looks at the sometimes conflicting signposts that each benchmark
presents and highlights ways that decision-makers can overcome or mitigate the effects of those problematic
issues.
Design/methodology/approach –After a short review of the IRR and NPV techniques, this Education
Briefing provides numerous examples of problematic issues that arise with certain cash flow profiles and
suggests how to address them.
Findings –Both the IRR and NPV provide simple benchmarks that can mislead the decision-makerwho is not
familiar with the nuances of both techniques.
Practical implications –This review should heighten the reader’s ability to spot characteristics of proposed
investments that may signal that a quick decision based on performance metrics may lead to disappointing
results. These characteristics include: scale effects, unusual cash flow patterns and/or investments with
dissimilar expected lives. Mutually exclusive investments merit special attention.
Originality/value –This is a review of existing performance measurement models.
Keywords Crossover rate, EAA, IRR, MIRR, NPV, NPV profile, Reinvestment rate, Replacement chains,
Rule of Signs
Paper type General review
Introduction
Forming an accurate value estimate of potentialinvestmentsisamongthemost
important tasks that confront real estate professionals and investors. They have a virtual
cornucopia of valuation methods from which to choose, but over the last 50 years, survey
results have shown that corporate managers and real estate investors in developed countries
have placed increasing reliance on the internal rate of return (IRR) and the net present value
(NPV) to help determine if a proposed investment makes financial sense [1].
Business managers and academics favour both techniques because, unlike most other
long-term evaluation methods, the IRR and NPV incorporate estimates of all after-tax cash
flows associated with the subject investment and both consider the time value of money.
NPV is calculated by subtracting the present value of the initial investment from the total
present value of the future cash flows, with the discount rate used to reduce future values to
present values normally set at the firm’s cost of capital when evaluating average risk
investments [2]. More formally, the formula for calculating NPV is:
JPIF
42,6
604
As this article is a briefing/insight commissioned by the editor, it has been subject to editorial review
only.
The current issue and full text archive of this journal is available on Emerald Insight at:
https://www.emerald.com/insight/1463-578X.htm
Journal of Property Investment &
Finance
Vol. 42 No. 6, 2024
pp. 604-613
© Emerald Publishing Limited
1463-578X
DOI 10.1108/JPIF-04-2024-0051
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