NET PRESENT VALUE Vs. THE INTERNAL RATE OF RETURN, YET AGAIN
| Author | A. J. Merrett |
| Published date | 01 February 1965 |
| Date | 01 February 1965 |
| DOI | http://doi.org/10.1111/j.1467-9485.1965.tb00751.x |
NET PRESENT VALUE Vs. THE INTERNAL RATE
OF
RETURN,
YET
AGAIN
A.
J.
MERRETT'
DR.
Myles
M.
Dryden in an article in this journal of November,
1964
attributed to Allen Sykes and myself views which, based as they were
on
remarks taken out of context, with
no
attempt to indicate the real
nature of our argument, call for some comment.
Dryden is anxious to demonstrate that there is an
'
overwhelming
'
case for net present value as against the internal rate
of
return. This
case, however, has not been demonstrated even plausibly either in
his article
or
any other to my knowledge. His argument is essentially
based
on
the proposition that any failure
of
a method in any test
we can devise constitutes
an
overwhelming case against it.
To
be
taken seriously, any of these short-comings have
to
be shown to be
(a) common and
(b)
important. Both
(a)
and (b) are empirical
questions of fact which Dryden makes no attempt whatever to con-
sider.
His arguments are familiar ones, the first being that the internal
rate
of
return may give rise to multiple solutions. This, he holds, makes
the internal rate of return
'
severely limited
'.
Multiple solutions are,
in fact, considered
in
great detail in our book2 where it is indicated
that there exist quite adequate simple methods of surmounting the
difficulty in the majority
of
the extremely
small
proportion
of cases
in which multiple solutions arise. This argument against the internal
rate
of
return, therefore, fails
on
both criteria (a) and (b). Dryden's
next argument is also the very familiar one that the two methods
may give different ranking in order
of
attractiveness. As we pointed
out in
our
book and as he freely concedes, where the company has
a
well-defined constant opportunity cost of capital and where we are
not dealing with mutually exclusive projects, either method
would
give exactly the same selection of projects. (As regards mutually
exclusive projects, it
is
hardly necessary to point out that this diffi-
culty, when it arises, is generally readily overcome by taking the
incremental cash flows between the alternatives.) Given this, there
are
no
serious objections against the internal rate
of
return
on
an
Capital Budgeting: Treatment
of
Uncertainty and Investment Criteria.
A.
J.
Merrett and Allen Sykes, The Finance and Analysis
of
Capita!
Projects (Longmans Green,
1963),
chapter
5.
116
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