Proposed Innovation in Financial Management Decisions

Down with IRR

I hate to get down on financial managers but why is IRR still being used?  The fact that the presumption of reinvestment at the same cost of capital as when the project started is ludicrous should be enough to convince them to  use any other method with the exception of payback.  Is it just the organizational entropy or the fear of upsetting the status quo?

Even though net present value yields more conservative decisions, internal rate of return remains a more frequently selected method for evaluating financial advantages of investments.  There may be a way to encourage use of present value without resorting to explaining dimensions of cash inflows.  Using the present value (PV) and the investment (I), a profitability index percentage (PIP) can be calculated.

PIP equation

Instead of looking to the weighted average cost of capital (WACC) and comparing the difference between it and IRR, analysts could then compare the PIP of a project to other projects without considering WACC at all.

Note from investopedia.com:

The weighted average cost of capital is the average of the costs of the debt or equity financing used to determine the amount of interest the company has to pay per dollar it finances. This value is often times used to “determine the economic feasibility of expansionary opportunities and mergers.”

Advertisements
Tagged with: , , , , , ,
Posted in Innovation Management

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: