Chapter Four

DISCOUNTING AND ALTERNATIVE INVESTMENT CRITERIA

4.1

Introduction

This chapter discusses the alternative investment criteria commonly used in the appraisal of
investment projects. The net present value of a project (NPV) criterion is widely accepted by
financial analysts and economists as the one that yields better results as compared to other available
criteria. However, some private investors also relied upon other criteria such as projects internal
rate of return (IRR), a benefit-cost ratio, and pay-back period criterion. The strengths and
weaknesses of these criteria are examined in this chapter in order to demonstrate why the NPV is
the most reliable criterion in the appraisal of investment projects. Section 4.2 explains the concept
of discounting and discusses the choice of discount rate. Section 4.3 of this chapter elaborates and
compares alternative investment criteria for the appraisal of investment projects.

4.2

Discounting

The nature of investment projects is such that their benefits and costs usually occur in different
periods over time. Because a given sum of money available now is considered to be worth more
than the same sum received in a future period, it is necessary to give greater weight to costs and
benefits that accrue earlier in time and lower weight to those that occur later. The greater value
placed on current rather than future costs and benefits arises because money available now permits
profitable investment or consumption between now and the future; hence, borrowers are willing to
pay a positive interest rate in order to have the use of the funds while lenders will demand an
interest payment.

Since an amount of $1 now will, if invested, grow to $(1+r) a year hence, it follows that an amount
B next year will have a present value of B/(1+r). Similarly, since an investment of $l now will grow
to $(1+r)n in n years, it follows that an amount B to be received in n years in the future will have a

present value of $B/(1+r)n. The greater the rate of discount, r, used and the further in the future the
date when an amount is to be realized, the smaller is its present value.

The net present value of a future stream of net benefits, (B0 - C0), (B1 - C1), . . . (Bn - Cn) can be
expressed algebraically as follows:

(4-1)

B0 C0

NPVr0 =

(1 + r)0
n

(4-2)

NPV0r =

t =0

Bn C n
B1 C1
+ .......... .. +
(1 + r )1
(1+ r ) n

( Bt C t )
(1 + r ) t

where n denotes the length of life of the project. The expression 1/(1+r)t is commonly referred to
as the discount factor for year t.

For purposes of illustration, the present value of the stream of net benefits over the life of an
investment is calculated in Table 4-1 by multiplying the discount factors, given in row 4, by the
values of the net benefits for the corresponding periods shown in row 3. The net present value of
$1000 is the simple sum of the present values of net benefits arising each period throughout the life
of the project.

In Equation 4-2 and this example, the net benefits arising during the project's life are discounted to
period zero. However, it is important to note that while the discounting of net benefits from
different periods and the size of the discount rate are important factors in the ranking of projects,
the particular point in time to which all the net benefits, i.e., benefits minus costs, in each period are
discounted, does not matter.

Instead of discounting all the net benefit flows to the initial year of a project we could evaluate the
project's stream of net benefits as of a year k, which may or may not fall within the project's
expected life. In this case all the net benefits arising from year zero to year k must be cumulated
2

forward at a rate of r to period k. Likewise, all net benefits associated with year's k+1 to n are
discounted back to year k at the same rate r. The expression for the net present value as of period
k becomes:
n

NPVkr =

(4-3a)

(Bt - Ct)(1+r)k-t

at year k.

t =0

Equation 4-3a, in turn, is a constant multiple of the net present value formula shown in equation 2.
By multiplying equation 4-2 by the constant (1+r)k, we obtain the expression:

(4-3b)

((Bt - Ct)(1+r)k) / (1+r)t

or

t =0

(Bt - Ct)(1+r)k-t
t =0

which is Equation 4-3a. The value of the constant (1+r)k is only a function of the rate of discount, r,
and the number of periods between the two dates to which the present values are calculated, k. As
the rankings of a set of numbers are not altered if they are all multiplied by the same constant, the
date to which the net benefits of the alternative projects are discounted will not affect the rank of
their respective net present values, provided that all projects being compared are evaluated as of
the same calendar date.

Table 4-1: Calculating the Present Value of Net Benefits from an Investment Project
Items

Year

1. Benefits
2. Costs

3247

4571

3525

2339

5000

2121

1000

1000

1000

1000

3. Net Benefits

-5000

-2121

+2247

+3571

+2525

+1339

4. Discount Factor at 6%

1.000

0.943

0.890

0.840

0.792

0.747

5. Net Present value = 1000

-5000

-2000 +2000

+3000

+2000

+1000

Figure 4-1: Adjustment of Cost of Funds through time

If funds currently are abnormally scarce

Rate of
discount
(percent)

Normal or historical
average cost of funds

If funds currently are abnormally abundant

(b)

Years from present period

Variable Discount Rates

To this point we have assumed that the rate of discount remains constant throughout the life of a
project. However, this need not be the case. Suppose that funds are very scarce at present
relative to the historical experience of the country. In such circumstances, we would expect to find
that the cost of funds will currently be abnormally high and the discount rate will most likely fall over
time as the supply and demand for funds return to normal. Alternatively, if funds are very plentiful at
present, we would expect the cost of funds and the discount rate to be below their long-term
average. In this case we would probably expect the discount rate to rise as the demand and supply
of funds return to their long-term trend over time. This process is illustrated in Figure 4-1.

Suppose, there is possibility that the discount rate will vary during the life of the project. If it can
be predicted, the net present value of a four year project should be calculated as,

(4-4a)

NPV

= (B 0 C 0 ) +

B1 C1
(1 + r1 )

B2 C2
(1 + r1 )( 1 + r 2 )

B3 C3
(1 + r1 )( 1 + r 2 )( 1 + r 3 )

where r1 is the one period discount rate for period 1, r 2 is the one period discount rate for period 2,

and r3 is the one period discount rate for period 3.

The general expression for the net present value of the project with a life of n years, evaluated as of
year zero, becomes:
n

(4-4b)

NPV = (B0 - C0) +

B
t =1
t
i =1

Ct

(1 + ri )

As in the case of the constant rate of discount, the actual calendar period to which projects are
discounted does not matter provided that the NPV's of the projects being compared are discounted
to the same date.

(c)

Factors Affecting Discount Rates for Public Sector Projects

For private sector investment, the most appropriate rate of discount is derived from the private cost
of funds the firm must pay to finance new investments. This cost of funds is derived as the weighted
average cost of funds obtained through the sale of equity (or retained earnings) and the cost of
borrowed funds.

However, this weighted average private financial cost of capital is largely irrelevant in the
determination of the discount rate for economic evaluation of projects. The correct discount rate
for the economic appraisal should reflect the economic return foregone by the economy as these
investment activities expand. This economic cost of capital will reflect the total economic return
given up by the economy because other investment activities are displaced (perhaps postponed)
and because private consumption is decreased in order to free up resources for the project to be
undertaken. When discussing the economic evaluation of investment projects in a later chapter in
this manual, the detailed methodology for measuring the economic opportunity cost of public funds
will be presented.

The purpose of calculating the net present value of a project is to determine whether the resources

used in the proposed project yield a return greater than the cost of resources as reflected by the
appropriate rate of discount. If so, the net present value will be positive; if not, the net present
value will be negative.

In order for the net present value of a government project to be meaningful, all the economic costs
and benefits should be included in the project profile before discounting. At the same time, the
economic opportunity cost of funds should be reflected in the rate of discount. When significant
distortions exist between the financial profile of costs and benefits and its economic counterpart, the
net present value of the financial cash flow will be misleading as an investment criterion. Whether or
not the project is a good in using resources, the decision should be based on the net present
value of the economic flow of net benefits. However, the financial cash flow plays a central role in
indicating whether the liquidity position of the firm can be maintained in order for it to survive from
year to year.
When there are private sector partners in a project, the calculation of net present value from the
private sector's point of view will be meaningful to them. This private net present value should not
be used by the government to decide whether it is a good use of resources from the public's
perspective.

4.3

Alternative Investment Criteria

Many different criteria have been used in the past to judge the expected performance of
investment projects. In this section, we review four of these criteria including net present value
criterion, the benefit-cost ratio, the pay-out or pay-back period and the internal rate of return. Of
these four, the net present value criterion is by far the most satisfactory, although it may have to be
slightly modified on occasion to take into account of particular constraints.

(A)

Net Present Value Criterion (NPV)

(i)

When to Reject Projects

In calculating the present value of an investment project, the first step is to subtract all the costs
6

incurred from the total benefits pertaining to each period to obtain net benefits. Secondly, a
discount rate is chosen which measures the opportunity cost of funds in alternative uses in the
economy, hence imputing a cost of funds to each project equal to the return foregone. When the
net present value of a project is measured in economic terms, a positive net present value implies
that the economy will be made better off with the project. However, a negative net present value
implies that the economy will be made worse off with the project. It is this implication of the net
present value criterion that leads us to the first version of this criterion that holds under all
circumstances.

Rule :

Do not accept any project unless it generates a positive net present value when
discounted by the opportunity cost of funds.

Assume that a government has the four following investment opportunities and no restrictions apply
to the amount it can borrow to finance desirable projects. The projects are discounted by the
opportunity cost of public funds.
Project A: Present Value costs $1 million, NPV + 70,000
Project B: Present Value costs $5 million, NPV - 50,000
Project C: Present Value costs $2 million, NPV + 100,000
Project D: Present Value costs $3 million, NPV - 25,000
In this situation, only projects A and C are acceptable. The country would be made worse off if the
government borrowed additional funds to finance projects B and D.

(ii)

Budget Constraints

Often governments cannot obtain sufficient funds at a fixed price to undertake all the available
projects having positive net present value. When such a situation arises, a choice must be made
among the projects to determine the subset that will maximize the net present value produced by the
investment package while fitting within the budget constraint. Thus the second version of the net
present value criterion is:

Rule: Within the limit of a fixed budget, choose that subset of the available
projects which maximizes net present value.

Because a budget constraint does not require that all the money be spent, this rule will prevent any
project that has a negative net present value from being undertaken. Even if not all the funds in the
budget are spent, the NPV generated by the funds in the budget will be increased if a project with a
negative NPV is dropped from consideration.

Suppose the following set of projects describes the investment opportunities faced by a government
department with a fixed budget for capital expenditures of $4.0 million.

Project E costs $1 million, NPV + 60,000

Project F costs $3 million, NPV + 400,000
Project G costs $2 million, NPV + 150,000
Project H costs $2 million, NPV + 225,000

With a budget constraint of $4 million we would explore all possible combinations that fit within this
constraint. Combinations FG and FH are impossible, as they cost too much. EG and EH are
within the budget, but are dominated by the combination EF which has a total NPV of 460,000.
The only other feasible combination is GH, but its NPV of 375,000 is not as high as that of EF. If
the budget constraint were expanded to $5 million, then project E should be dropped and projects
H undertaken in conjunction with project F. In this case, the net present value from this package of
projects (H and F) is expected to be $625,000 which is greater than the N.P.V. of the next best
alternative (F and G) of $550,000.

Suppose that project E, instead of having an N.P.V. of +60,000, had an N.P.V. of -$60,000. If
the budget constraint were still $4.0 million, then the best strategy would be to undertake only
project F which would yield a net present value of $400,000. In this case, $1 million of the budget
should be put to use in the capital market even though it is the budget constraint which is preventing
8

us from undertaking the potentially good projects, G and H. When the discount rate measures the
full opportunity cost of the public funds, then choices that entail a reduction in net present value
should be rejected even if there is enough money available in the budget to undertake them.
(iii)

Comparing Mutually Exclusive Projects

Many times in the appraisal of investment projects, we come across a situation where we have to
make a choice between strictly alternative projects. It may not be possible for both projects to be
undertaken for technical reasons. For example, in building a road between two towns, there are
several different qualities of road that can be built given that only one road will be built. Also a
particular building site cannot be used for two different purposes at the same time. Therefore, the
problem facing the investment analyst is to choose from among the mutually exclusive alternatives,
that project which will yield the maximum net present value. This can be expressed in the form of
the following rule:
Rule:

In a situation where there is no budget constraint but a project must be chosen

from mutually exclusive alternatives, we should always choose the alternative that
generates the largest net present value.

Assume that we must make a choice between the following three mutually exclusive projects:
Project I: PV costs $1.0 million, NPV $300,000
Project J: PV costs $4.0 million, NPV $700,000
Project K: PV costs $1.5 million, NPV $600,000
In this situation, all three are good potential projects and would yield a positive net present value.
However, only one can be undertaken.
Project J involves the biggest expenditure, it also has the largest NPV of $700,000. Therefore,
project J should be chosen. Although, project K has the biggest NPV per dollar of investment,
this is not relevant if the discount rate reflects the opportunity cost of the funds. On the incremental
investment of $2.5 million, if we undertake project J rather than K, there is an incremental gain in
net present value of $100,000 over and above the opportunity cost of the additional investment.
Therefore, project J is preferred.
9

In doing project I versus project J, it is assumed that we could only expect to get an NPV of 0 by
investing the remaining funds in a "marginal" project L. This is necessarily implied by the use of the
opportunity cost of funds as the rate of discount. Thus, the combination I plus another project "L"
that would also cost $4 million, would have only an NPV of $300,000.

(iv)

Constraints When Choosing Between Alternative Projects Using the NPV Criterion

The net present value of a project is not only an index for ranking projects, it also has a more
substantive meaning. NPV of a project measures the value or surplus generated by a project over
and above what would be gained or generated these funds if not used in these public sector
investments.

In some situations, an investment in a facility such as a road can be carried out by a series of short
projects or one or more longer ones. If the return on the expansion of the facility over its lifetime is
such as to be an investment opportunity that would yield a positive net present value, it would not
be meaningful to compare the net present value of a project that produced road services for the full
duration, to the net present value of a project that produced road services for only part of the
period if it is expected that the short project would be repeated through time.
This same issue arises when alternative investment strategies are evaluated for electricity generation.
It is not correct to compare the net present value of a gas turbine plant with a life of ten years to a
coal generation station having a life of 30 years, if it is expected that throughout the entire 30-year
period, the scarcity of electricity generation facilities will yield above normal rates of return to
investment. In such a case, we must compare investment strategies which have approximately the
same length of life. This may involve the comparison of a series of gas turbine projects followed by
other types of generation which in total have the same lengths of life as the coal plant.

In most project evaluation situations it is not expected that the demise of the shorter project will give
rise to the subsequent project opportunities with supra-marginal or above normal rates of return.
As long as this is so, it is quite appropriate to compare projects with different lengths of life, with the
10

net economic benefit profiles of all projects being discounted at the economic opportunity cost of
public funds.

When it is expected that projects of short lives will lead to further projects which yield supramarginal returns, the comparison of alternative projects of different lives which will provide the
same services at a point in time will require us to make adjustments to our investment strategies
so they span approximately the same period of time. One such form of adjustment is to
consider the same project being repeated through time until the alternative investment strategies
have the same lengths of life. For example, suppose we wish to build a road where the following
three types of road surfaces are to be considered.

Duration of Road
Alternative A: Gravel Surfaced road

3 years

Alternative B: Oil (tar) surfaced road

5 years

Alternative C: Cold mix asphalt surface road

15 years

If we compare the net present values of these three alternatives with lives of 3, 5 and 15 years, the
results could be misleading. However, a correct comparison of these projects can be made if we
construct a project or investment strategy which consists of five gravel road projects, each one
undertaken at a date in the future when the previous one is worn out. Hence, we would compare
five gravel road projects, extending fifteen years into the future with three tar surface roads and one
asphalt road of fifteen years' duration. This comparison can be written as follows:
Duration of Road
(a) (A + A + A + A + A)
(1-3,4-6,7-9,10-12,13-15)

15 years

(b) (B + B + B)
(1-5,6-10,11-15)

15 years

(c) (C)
(1-15)

15 years

11

Alternatively, it might be preferable to consider investment strategies made up of a mix of different

types of road surfaces through time such as:

Duration of Road
(d)

(A + A + A + B + C)
(1-3,4-6,7-9,10-14,15-29)

(e)

29 years

(A + B + B + C)
(1-3,4-8,9-13,14-28)

28 years

In this situation a further adjustment should be made to the 29 year strategy (d) to make it
comparable to strategy (e) that is expected to last for only 28 years. This can be done by
calculating the net present value of the project after dropping the benefits accruing in year 29 from
the NPV calculation while at the same time reducing the present value of its costs by the fraction
PVB29/PVB, where PVB denotes the present value of the benefits of the entire strategy, including
year 29, and PVB 29 is the present value of the benefits that arise in year 29. In this way the
present value of the costs of the project are reduced by the same fraction as is the present value of
its benefits so that it will be comparable in terms of both costs and benefits to the strategy with the
shorter life.

(B)

Benefit-Cost Ratio Criterion

This criterion for ranking investment projects has been one of the rules most widely used by
investment analysts. Unfortunately, unless used with great care, it can yield very misleading advice
on the relative attractiveness of investment opportunities. The benefit-cost ratio is calculated by
dividing the present value of benefits by the present value of costs, using the opportunity cost of
funds as the discount rate.
Present Value Benefits
Benefit-Cost Ratio (R)=
Present Value Costs

12

Using this criterion, we would require that for a project to be acceptable the ratio (R) must have a
value greater than 1. Also, for choices among mutually exclusive projects the rule would be to
choose the alternative with the highest benefit-cost ratio.
However, we can easily see that this criterion may give us an incorrect ranking of projects if the
projects differ in size. Consider again the cases of mutually exclusive Projects I, J and K, which
were introduced above:
Project I:

PV costs = $1.0 million, PV benefits = $1.3 million

NPV = $.3 million; R = 1.3

Project J:

PV costs = $8.0 million, PV benefits = $9.4 million

NPV= $1.4 million ; R = 1.175

Project K:

PV Costs = $1.5 million, PV benefits = $2.1 million

NPV = $0.6 million ; R=1.4

In this example we find that if the projects were ranked according to their benefit-cost ratios we
would choose project K. However, we know that the NPV of project K is less than the NPV of
project J. Hence, in this case the ranking of the projects according to their benefit-cost ratio would
lead us to an incorrect investment decision.
The second problem associated with the use of the benefit-cost ratio, and perhaps its most serious
drawback, is that the benefit-cost ratio of a project is sensitive to the way in which costs have been
defined by the accountants in setting out the cash flows. For example, if a good being sold is taxed
at the manufacturer's level, the cash flow item for receipts could be recorded either net of these
sales taxes or gross of sales taxes with sales taxes recorded as an offsetting cash outflow.
When we have current project costs, costs can also be recorded in more than one way. The
benefit-cost ratio again will be altered by the way these costs are accounted for. Let us consider
the following example:
13

Project A

Project B

Present value of gross benefits

2000

2000

Present value current costs

500

1800

Present value capital costs

1200

100

Benefit-cost ratio if current

cost netted out of benefits

R1A =(2000-500)/1200

=1. 25

R 1B=(2000-1800)/100
=2.00

Because R1B > R1A project B would be preferred to project A according to the
benefit-cost ratio criterion.
Project A
Benefit-cost ratio if current
costs added to Capital Costs

R2A = 2000/1700
=1.18

Project B
R2B = 2000/1900
=1.05

Because R2A > R2B, project A would now be preferred to project B according to this criterion.

Hence, we find that the ranking of the two projects will be reversed depending on the treatment of
current costs. On the other hand, the net present value of a project is not sensitive to the way the
accountants treat costs. Unfortunately, project appraisal is full of arbitrary decisions about netting
benefits and costs and each one will affect the benefit-cost ratio. As a result, the net present value
is far more reliable than the benefit-cost ratio as a criterion for project selection.

(C)

Pay-Out or Pay-Back Period

The pay-out or pay-back rule had been widely used in making investment decisions. Because it is
easy to apply and puts a large premium on projects which have a quick pay-back it has been a
popular criterion in making business investment choices. Unfortunately, it can give misleading
results especially in the cases of investments with a long life and whose future benefits and costs are
known with a considerable degree of certainty.

14

In its simplest form the pay-out period measures the number of years it will take for the
undiscounted net benefits (positive net cash flows) to repay the investment. An arbitrary limit is set
on the maximum number of years allowed and only those investments having enough benefits to
offset all investment costs within this period will be acceptable.

A more sophisticated version of this rule compares the discounted benefits over a given number of
years at the beginning of the project with the discounted investment costs. However, the implicit
assumption of the pay-out period criterion is that benefits accruing beyond the time set as the payout period are so uncertain that they should be neglected. It also ignores any investment costs that
might occur beyond that date, such as the landscaping and replanting costs arising from the closure
of a strip mine.

While there is no argument with the idea that the future is more uncertain than the present, it is not
realistic to assume that beyond a certain date the mean expected value of net benefits is zero. This
is particularly true of long term investments such as bridges, roads and buildings. For long-lived
organizations, such as large corporations and governments, there is no reason to expect that all
quick yielding projects are superior to long-term investments. Let us consider the example
illustrated in Figure 4-2.

Figure 4-2: Comparison of two projects with differing lives using Pay-Out Period
Ba

Bt-Ct

Bb

0
Ca =Cb

t*
Pay out
period for
project a

15

tb
Pay out period
for Project b

Both projects are assumed to have identical costs (i.e., C a = C b). However, the benefit profiles of
the two projects are such that project A has greater benefits in each period until period t*. From
period t* to tb, project A yields zero net benefits, but project B yields positive benefits (the shaded
area in Figure 4-2).

With a pay-out period of t* years, project A will be preferred to project B because for the same
costs it yields larger benefits earlier. However, in terms of net present value of the overall project, it
is very likely that project B, with its greater benefits in later years will be significantly superior.
Hence, in such a situation, the pay-back period criterion would give the wrong recommendation for
choice among investments.

(D)

Internal Rate of Return Criterion

The internal rate of return is a statistic that has seen considerable use by both private and public
sector investors as a way of describing the attractiveness of a particular project. However, it is not
a reliable investment criterion, although on some occasions it is a useful statistic to summarize the
profitability of an investment.
The internal rate of return (IRR) and the net present value (NPV) criteria are related in the way they
are derived. To calculate the net present value the discount rate is given and used to find the
present value of benefits and costs. In contrast, when finding the IRR of a project the procedure is
reversed. Instead of selecting the rate of discount, the NPV of the net benefit stream is set equal to
zero; the IRR is the rate of discount which will bring this about.

The internal rate of return for a project (K) is obtained by the solution of the following equation:

t= 0

(B t C t )
= 0
(1 + r ) t

16

Costs are defined to include capital outlays, labor, materials, energy and transport costs and
maintenance and repair expenditures. Costs do not include depreciation charges or actual or
imputed interest charges, as the internal rate of return itself reflects the implicit `net interest yield' of
the project and in this sense allows for the depreciation of the project's cost. Thus, if a project has
a capital cost of 100 in year 0 and a benefit of 120 in year 1 with operating cost of 20, the net
effect of the operation of the project would be -100 in year 0 and +100 in year 1. The capital
invested would be barely recovered one year later. Such a project would have an internal rate of
return of zero and indicate that no more than capital recovery can be expected from it. On the
other hand, if the project were to have a benefit of 130 in year 1, with an operating cost of 20 in
that year, its internal rate of return would be ten percent, indicating that the capital invested in the
project will produce a yield of ten percent after allowing for capital recovery. Finally, if the benefit
in year 1 were merely 110, together with an operating cost of 20, the value of B1 - C1 would be 90
and the internal rate of return would be minus ten percent, indicating that the project is not capable
of yielding sufficient benefits to cover the cost of the invested capital.

Figure 4-3: Time Profiles of the Incremental Net Cash Flows

for Various Types of Projects
Incremental Net Cash
Flow (a) Bt-Ct

Incremental Net
Cash Flow (b) Bt-Ct

Time
_

Time
_

17

The great advantage of the internal rate of return lies in the fact that it can be calculated on the basis
of project data alone. In particular, its calculation does not require data on the opportunity cost of
capital. However, the disadvantages of the internal rate of return are severe and necessitate that it
be used with the greatest caution. For a typical project with an initial period of investment, (during
which the value of Bt - Ct is negative) followed by a period in which its net benefit is always
positive, there is a unique solution for the internal rate of return.

If on the other hand, we have a project that has a time-profile of net benefits that cross as zero
more than once, as illustrated in Figure 4-3 (a), it may not be possible to determine a unique internal
rate of return. Examples of such projects are those cases in which major items of equipment must
be replaced from time to time, giving rise to negative net benefits in the years of reinvestment. Road
projects also have this characteristic as major expenditures on resurfacing must be undertaken
periodically for them to remain serviceable.

There are also cases where the termination of a project entails substantial net costs. Examples of
such situations are the land reclamation costs required at the closing down of a mine to meet
environmental standards or the agreement to restore rented facilities to their former state. These
case are illustrated by Figure 4-3(b). Project profiles of the type illustrated in Figures 4 -3(a) and
4- 3(b) may yield multiple real number solutions for the internal rate of return; these multiple
solutions, when present, face us with a problem of choice from which there is no escape. Let us
consider the simple case of an investment of 100 in year 0, a net benefit of 300 in year 1, and a net
cost of 200 in year 2. Obviously, one solution for the internal rate of return is zero, for at a zero
discount rate the present value of benefits is just equal to the present value of costs.

Solution 1: (K = 0):
-100 + 300/(1.0)1-200/(1.0)2 = -100 + 300 200 = 0
The other solution is 100 percent and is illustrated as follows:

18

Solution 2: (K = 1):
= -100 + 300/(2) -200/(4) = -100 + 150 50 = 0
Even when the internal rate of return can be unambiguously calculated for each project under
consideration, its use as an investment criterion poses difficulties when some of the projects in
question are strict alternatives. This can come about in three ways: (i) projects are strict
alternatives but require different sizes of investment, (ii) projects are strict alternatives but have
different lengths of life, (iii) projects are strict alternatives, but they represent different timing for a
project. In each of these three cases, the internal rate of return can lead to the incorrect choice of
project.

(i)

Projects of Different Sizes and Strict Alternatives

Let us consider a case where project A has an investment cost of 1000 and is expected to generate
net benefits of 300 each year in perpetuity. Project B is strict alternative to project A and has an
investment cost of 5000. It is expected to generate net benefits of 1000 each year in perpetuity.
These two alternatives can be shown in the following table.
0

Project A

-1000 + 300

+ 300

+ 300 + 300

Project B

-5000 +1000

+1000

+1000 +1000

________
.....
___________
.....
.....

The internal rate of return for project A is 30 percent (K A =300/1000) while the internal rate of
return for project B is 20 percent, (K B = 1000/5000) . However, when we calculate the net
present value of project A using a ten percent discount rate, we find that it is equal to $2000 while
the net present value of project B is $5000.

NPVA = (300/r)-1000
= 3000 1000
= 2000

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NPVB =(1000/0.1)-5000
= 10,000 - 5000
= 5000
In comparing the net present values of these projects the assumption is being made that if project A
were undertaken the difference between its cost and that of project B, i.e., 4000, either would be
invested in a project or the capital market and would yield a NPV of zero. This assumption is
consistent with the principle underlying the net present value criterion that the discount rate is chosen
so as to reflect the opportunity cost of capital.

In this example, if a choice must be made between projects A and B, the internal rate of return
would indicate to us to choose project A because it has an I.R.R. of 30 percent while the I.R.R. of
project B is only 20 percent. However, the fact that project B is larger enables it to produce a
greater net present value even if its internal rate of return is smaller. The net present value criterion
would therefore tell us to choose project B. From this illustration we see that when a choice has to
be made among mutually exclusive projects with investments of different sizes, the use of the internal
rate of return criterion can lead to the incorrect choice of investment projects.

(ii)

Projects have Different Lengths of Life and Are Strict Alternatives

Suppose two projects are under consideration of finding ways to reforest a piece of land with
different varieties of rapidly growing trees. Project A calls for the planting of a species that can be
harvested in five years. Project B uses a type of tree that can only be harvested after ten years.
The only cost is that of $1000 per acre for planting, which is the same for both types of trees. It is
assumed that there are no maintenance costs through the life of the project. Also, due to the type of
crop and what it takes out of the soil, it is assumed that neither of the projects can be repeated.
After harvesting the trees, the land is to be used for another purpose that will yield a net present
value of zero. Given an economic opportunity cost of capital of eight percent, the two projects can
be analyzed as follows:

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Project A

Project B

Initial Investment:

$1000 in year 0

$1000 in year 0

Benefits:

$3200 in year 5

$5200 in year 10

NPV at 8%

-1000 + (3200)/ (1.08)5

NPVA = 1,177.86

NPVA <NPVB
Internal Rate of Return:

-1000+(5200)/ (1.08)10
NPVB = 1,408.60

0=-1000+(3200)/ (1+KA )5
KA = .262

0=-1000 +(5200)/(1+KB )10

KB = .179

KA > KB
According to the net present value criterion, project B is preferred because it has the largest NPV.
However, according to the internal rate of return criterion, project A is preferred because its
internal rate of return is largest. Therefore, the internal rate of return is an unreliable criterion for
project selection when the choice is between alternative projects having different lengths of life.
(iii)

Projects Represent Different Timings in Same Project, Hence are Strict Alternatives

In this case, we have two projects whose benefit streams differ simply because they are started at
different times. They are summarized as follows:
Project A

Project B

Initial Investment:

Year 0 = 1000

Year 5 = 1000

Benefits:

Year 1 = 1500

Year 6 = 1600

NPVA = 388.88

NPVB = 327.36

NPVA
Internal Rate of Return:

>

NPVB

0= -1000(1500)/ (1+KA)1
KA = 0.5

<

0=-1000+(1600)/ (1+KB)1

KB = 0.6

Evaluating these two projects according to the net present value criterion would lead us to choose
project A over project B because NPVA > NPVB. However, we find that K B > K A, leading us to
choose project B if we use the internal rate of return criterion. Again, because projects A and B
are strict alternatives, the IRR criterion can cause us to make the incorrect choice of project.

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REFERENCES
1. Harberger, A. C., Project Evaluation: Collected Papers, MacMillan 1972, Chapter 2.

2. Lessard Donald R. and Wisecarver Daniel L., The Endowed Wealth of Nations Versus the
Internal Rate of Return, Development Discussion Paper 75, Harvard Institute of International
Development, July 1979.

3. Roemer Michael and Stern, Joseph J. The Appraisal of Development Projects: A Practical
Guide to Project Analysis with Case Studies and Solutions. New York, Praeger, 1975.

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