Thuan Trinh

MSE 304 SP17

Individual Article Assignment
Citation:
Hartman, Joseph C., and Ingrid C. Schafrick. "The relevant internal rate of return." Engineering
Economist, vol. 49, no. 2, 2004, p. 139+. Expanded Academic
ASAP, libproxy.csun.edu/login?url=http://go.galegroup.com/ps/i.do?p=EAIM&sw=w&u=c
sunorthridge&v=2.1&id=GALE%7CA137876352&it=r&asid=4347a78602e19b1e5774cdc
802f58d54. Accessed 2 May 2017.

The Relevant Internal Rate of Return

Abstract:
In this article we present a method for determining project acceptability in the presence of multiple
internal rates of return. An internal rate of return is an interest rate that equates the present worth of
a cash flow stream to zero. When unique, it provides valuable information about the return on the
investment and is often viewed as a measure of efficiency. Unfortunately, this analysis is clouded
when there are multiple internal rates of return, which can occur when a project is defined by a
mixture of positive and negative cash flows. While many methods have been presented in the
literature to deal with this problem, we believe ours to be unique in that it does not rely on the
computation of another measure of worth, but rather, the identification of the relevant rate of return
from the set of internal rates of return. We show that this rate always produces decisions consistent
with present worth under the assumption that at least one real internal rate of return exists. In doing
so, we provide new definitions of when a project is borrowing from, or loaning to, the firm. These
definitions help in understanding the meaning of multiple internal rates of return, which is also
discussed.

Full Text:
The internal rate of return (IRR), mathematically defined as the interest rate that equates the present
worth of a series of cash flows to zero, is and has been a popular measure of worth for purposes of
project evaluation. When unique, it defines the return achieved by an investment (or true cost of a
loan) and can often be viewed as a measure of efficiency. This explains its popular application,
despite many of its well-documented problems.

For decision-making purposes, the IRR can be compared to the discount rate for accepting and
rejecting projects. The discount rate goes by many names in the literature, including the cost
of capital, marginal growth rate, minimum attractive rate of return, and hurdle rate. We will use the
term minimum attractive rate of return (MARR) in this article. To accept an investment project, the
IRR must be greater than the MARR. To accept a loan, the IRR must be less than the MARR. When
the IRR is equivalent to the MARR, then we are indifferent about the loan or investment opportunity.
There are many documented troubles with respect to the IRR, including the difficulty in solving for
the rate (when compared to present worth), as it often involves solving a high-order polynomial
equation. This concern has been mitigated by the use of personal computers. Additional concerns
include multiple IRRs, complex valued IRRs, and no IRR for a given project. In these situations, it is
difficult to interpret the IRR (if one exists), and analysis is not straightforward. The other well-
documented issue with the internal rate of return is that it requires mutually exclusive projects to be
analyzed incrementally.
In this article, we address the issue of multiple IRRs, as identified by Lorie and Savage (1955) in
their seminal work. For multiple IRRs to occur, there must be "initial cash outlays, subsequent net
cash inflows, and final cash outlays" (Lorie & Savage, 1955, p. 237). They illustrated this by way of
an investment in an oil pump. The investment is described by an initial cash outlay followed by
periods of net revenues and ending with a negative cash flow attributed to the removal and cleanup
of the oil extracting location. Since there are many IRRs, it is unclear which IRR, if any, determines
whether to invest in the oil pump. Therefore, based on this scenario, Lorie and Savage claim, "the
rate-of-return criterion for judging the acceptability of investment proposals is ambiguous or
anomalous" (Lorie & Savage, 1955, p. 237).

Since their work, a number of methods have been proposed that define "equivalent" rates of return.
(See, for example, Athanasopoulos, 1978; Baldwin, 1952; Lin, 1976; Solomon, 1956). As noted by
Bernhard (1979), the "magnitudes of any of the rates of return can be difficult to interpret and hence
easily misunderstood" (p. 166). These rates are often referred to as modified, external, or average
rates of return. Teichroew, Robichek, and Montalbano (1965) classify projects as either investments,
loans, or mixed investments and define a procedure to identify the return on invested capital (ROC).
This value, when compared to the MARR, determines whether a project should be accepted or
rejected. Its decisions are consistent with present worth.

Cannaday et al. (1986) describe a technique that determines which, if any, of the IRRs are relevant
for investment projects. Hajdasinski (1987) extended their work to the case of a borrowing stream
but illustrated that these techniques cannot deal with cash flows with duplicate roots, multiple
relevant roots, or when the interest rate varies with time and when the MARR falls outside the range
of real internal rates of return.

Recently, Hazen (2003) defined a method where any IRR could be used to make the project
selection decision. The method entails defining the investment balance of the cash flow stream for
any IRR and analyzing it using the MARR. The method is consistent with present worth.

In this article, we follow the work of Cannaday, Colwell, and Paley (1986) (and later Hajdasinski,
1987) by identifying the relevant internal rate of return from the set of internal rates of return. Thus,
we do not require the computation of another measure of worth. Rather, we partition a project
according to periods of borrowing and/or loaning as defined by the discount rate. From these
definitions, the relevant IRR is defined when locating the MARR among the partitioned data. We
believe this method allows for an analysis of the rate of return that is meaningful. We prove that the
method is consistent with present worth, even in the presence of complex roots, under the
assumption that at least one IRR is real.

This article proceeds as follows: We define our notation and projects in the next section, and then
we define our method for the case of real roots, followed by two examples. Then we expand the
method to the case of complex roots, again followed by two examples. In the final two sections we
prove the consistent relationship with present worth and attempt to shed light on the meaning of
multiple roots.

DEFINITIONS AND NOTATION

Define a discrete cash flow stream as [x.sub.0], [x.sub.1] ..., [x.sub.n], where n ranges from one to
the horizon, possibly infinity. The present worth of a project for an interest rate i, P W(i), is defined
as:

P W(i) = [x.sub.0] + [x.sub.1]/[(1 + i).sup.1] + [x.sub.2]/[(1 + i).sup.2] + ... + [x.sub.n]/[(1 + i).sup.n]

The future worth of a project (at time n) for an interest rate i, F W(i), is defined as:

F W(i) = [x.sub.0][(1 + i).sup.n] + [x.sub.1][(1 + i).sup.n-1] + [x.sub.2][(1 + i).sup.n-2] + ... + [X.sub.n]

The internal rate of return, defined as [i.sup.*], is the rate that equates the present worth, or
equivalent future worth, to zero. Note that there may be multiple [i.sup.*].

P W([i.sup.*]) = [n.summation over (t=0)] [x.sub.t]/[(1 + [i.sup.*]).sup.t] = 0

A conventional investment, as originally defined by Bierman and Smidt (1993), "is an investment that
contains one or more negative cash outflows, followed by one or more positive cash inflows"
(Bussey & Eschenbach, 1992, p. 188). A non-conventional investment is an investment that
"intersperses the positive and negative cash flows" (Bussey & Eschenbach, 1992, p. 188).

The traditional definition of a pure investment is one in which the firm has money invested in the
project during every period of its life (Teichroew, Robichek, & Montalbano, 1965, pp. 155-156). The
project's investment balances (also referred to as unrecovered balances or project balances) are
calculated at the internal rate of return, [i.sup.*], and are either zero or negative throughout the
project's life n. The firm does not borrow from the project at anytime during its life and it exactly
recovers its investment at the end of the project's life, earning interest at [i.sup.*] in the interim
periods (Bussey & Eschenbach, 1992, p. 189).

For each period t, the investment balance is defined as:

F[W.sub.t]([i.sup.*]) = [t.summation over (m=0)][x.sub.m][(1 + [i.sup.*]).sup.t-m] [less than or equal

to] 0 [for all]t = (0, 1, ..., n - 1)

And at the end of the life n:

F W([i.sup.*]) = [n.summation over (t=0)] [x.sub.t][(1 + [i.sup.*]).sup.n-t] [equivalent to] 0

Conversely, a pure loan has project balances that are always non-negative and the future worth is
equal to zero at the internal rate of return.

A mixed investment is an investment in which the firm has money invested in the project during
some periods and the firm owes the project money during others (Teichroew, Robichek, &
Montalbano, 1965, p. 156). A mixed investment does not qualify as a pure investment or a pure loan.
Based on these definitions, a conventional investment can only be a pure investment, while a non-
conventional investment can be either a pure or a mixed investment (Bussey & Eschenbach, 1992,
p. 189).

We do not dispute these definitions; however, we provide a different perspective. Define the slope of
the P W(i) function according to its first derivative as:

dPW(i)/di = -[x.sub.1]/[(1 + i).sup.2] - [2x.sub.2]/[(1 + i).sup.3] ... - [nx.sub.n]/[(1 + i).sup.n+1]

Further, we define a project as a pure investment (from the perspective of the firm) if for all i in (-1,
[infinity]):

dPW(i)/di < 0
If one assumes that the interest rate represents the cost of capital, then this definition is intuitive as
the value of an investment will decrease with an increase in the cost of capital. This is captured by
the slope term, as any increase in the interest rate leads to a decrease in the present worth.

We define a project as a pure loan (from the perspective of the firm) if for all i in (-1, [infinity]):

dPW(i)/di > 0

Again, assuming the interest rate can be interpreted as the cost of capital, an increase in the cost of
capital makes a loan (with a fixed cost of capital) more attractive (an increasing present worth) from
the perspective of the entity providing the loan.

A mixed investment is defined by both positive and negative first derivatives over the interest rate
interval (-1, [infinity]). A firm is considered loaning to a project (or project is borrowing from the firm)
when the first derivative of present worth with respect to i is decreasing. Thus, for a given interest
rate i, a firm is loaning to a project if:

dPW(i)/di = -[x.sub.1]/[(1 + i).sup.2] - [2x.sub.2]/[(1 + i).sup.3] - ... - [nx.sub.n]/[(1 + i).sup.n+1] < 0

A firm is considered borrowing from a project (or a project is considered loaning to the firm) when the
slope on the graph of the present value with respect to i is increasing, or:

dPW(i)/di = -[x.sub.1]/[(1 + i).sup.2] - [2x.sub.2]/[(1 + i).sup.3] - ... - [nx.sub.n]/[(1 + i).sup.n+1] < 0

A maximum or minimum point of PW(i) occurs at [bar.i]. At this point, a project changes from an
investing to a borrowing opportunity, or vice versa. The maximum or minimum occurs when:

dPW(i)/di = -[x.sub.1]/[(1 + i).sup.2] - [2x.sub.2]/[(1 + i).sup.3] - ... - [nx.sub.n]/[(1 + i).sup.n+1] < 0

Clearly, with any change in the interest rate, the influence of cash flows change when computing the
present worth. A sign change in the slope of the present worth function signifies that the influence of
cash flows has changed enough to alter the direction of the function, thus changing it from a loaning
to a borrowing opportunity, or vice versa. Note that at the values of [bar.i], the project is defined
neither as loaning nor as borrowing. These terms will be used to explain the new method throughout
the rest of this article.

MULTIPLE IRR SOLUTION PROCEDURE

We now outline our procedure to determine project acceptability in light of multiple internal rates of
return. For simplicity, we first introduce our method under the assumption that there are no complex
roots and at least one real internal rate of return.

1. Using the cash flow stream, define the present worth as a function of the interest rate i and solve
for all internal rates of return [i.sup.*]. These can be found with any root-finding program (such as
Maple, 2003) or for the case of real roots by graphing the function.

2. Take the first derivative of the present worth function and set it equal to zero to identify all
maximum and minimum points, [bar.i]. For k internal rates of return, [i.sup.*.sub.1], [i.sup.*.sub.2], ...,
[i.sup.*.sub.k] there will exist k - 1 optimal points, [[bar.i].sub.1], [[bar.i].sub.2], ..., [[bar.i].sub.k-1].
3. Partition the graph at the maximum and minimum points, [bar.i], and determine the investment
type (borrowing or loaning) for each partition. For k internal rates of return there will exist k partitions
and at most one IRR for each partition.

(a) The first partition is defined as (-1, [[bar.i].sub.1]).

(b) The last partition is defined as ([[bar.i].sub.k-1], [infinity]).

(c) All other partitions are defined as ([[bar.i].sub.j], [[bar.i].sub.j+1] [for all] j = (1, 2 ..., k - 2).

Based on the earlier definitions of loaning and borrowing, the firm is loaning to a project (investing) if
for all interest rates i in the partition:

dPW(i)/di < 0

or borrowing if:

dPW(i)/di > 0

Note that the direction of the slope (positive or negative) is fixed for a given partition. Further note
that for the remainder of this article, we refer to partitions as either loaning or borrowing. This is from
the perspective of the firm in that a firm is either loaning to, or borrowing from, the project. A loaning
partition is equivalent to that partition of a project being defined as an investment while a borrowing
partition is equivalent to that partition of a project being defined as a loan.

4. Locate the partition in which the MARR resides. (If the MARR is equal to an optimal point [bar.i],
then choose a partition on either side of the MARR. Either partition will reach the same conclusion.)
The IRR that resides in the partition with the MARR is the relevant IRR, or [IRR.sup.*]. Compare the
MARR to the [IRR.sup.*] as follows.

(a) If the partition is defined by an investment project such that the firm is loaning to the project, then:

* If the [IRR.sup.*] > MARR, accept.

* If the [IRR.sup.*] = MARR, indifferent.

* If the [IRR.sup.*] < MARR, reject.

(b) If the partition is defined by a loan such that the firm is borrowing from the project, then:

* If the [IRR.sup.*] < MARR, accept.

* If the [IRR.sup.*] = MARR, indifferent.

* If the [IRR.sup.*] > MARR, reject.

We will illustrate this method with two examples from Hazen (2003).

Example 1. Consider the cash flow stream (-1, 6, -11, 6). For discussion purposes, the present worth
of the cash flow is graphed as a function of the interest rate in Figure 1. We now illustrate the
decision procedure with an MARR of 10%.

[FIGURE 1 OMITTED]

1. The present worth function is

PW(i) = -1 + 6/[(1 + i).sup.1] + -11/[(1 + i).sup.2] + 6/[(1 + i).sup.3]

and the IRRs are [i.sup.*] = 0, 1, and 2.

2. The first derivative is

dPW(i)/di = - 6/[(1 + i).sup.2] + 22/[(1 + i).sup.3] - 18/[(1 + i).sup.4]

and the minimum and maximum points are [bar.i] = 0.232408 and 1.4342582.

3. Partition the project as: (-1, 0.232408), (0.232408, 1.4342582), and (1.4342582, [infinity]). Based
on the definition of loaning to a project, Partitions 1 and 3 are defined as loaning, and Partition 2 is
defined as borrowing from a project as illustrated in Figure 1. This is readily obvious from the graph
but can also be determined by computing the slope at an interest rate in each partition.

4. The MARR of 10% is found in Partition 1, which is a loaning partition. The IRR in Partition 1 is
[i.sup.*] = 0, which we define as [IRR.sup.*]. As the partition is loaning and the [IRR.sup.*] < MARR,
we reject the project.

Note the decisions for all relevant minimum attractive rates of return in Table 1, as illustrated in
Figure 1, are consistent with present worth. This will be formalized later.

Example 2. Consider the cash flow stream (-1, 4, -4). The present worth of the cash flow is graphed
as a function of the interest rate in Figure 2. This is an interesting example, as there is only one
internal rate of return. However, the project is a mixed investment, as the derivative is both positive
and negative for different interest rates, which clouds the analysis. The lone internal rate of return is
defined as [i.sup.*] = 1 with the only maximum point at [bar.i] = 1. This leads to partitions (-1, 1) and
(1, [infinity]) with the MARR residing in the first partition. With a positive slope, this partition is
defined as a borrowing partition, leading to the decision to reject the project as the MARR <
[IRR.sup.*]. Decisions for all interest rates are given in Table 2.

[FIGURE 2 OMITTED]

ACCOUNTING FOR COMPLEX ROOTS

The above examples have only contained real roots. We now address how to deal with complex
roots in our procedure. Steps 1, 2, and 3 are defined as previously, but the partitioning in Step 4
must be re-addressed as follows.

4. Identify all partitions from Step 3 that contain complex roots. "Collapse" these partitions such that
the new remaining partitions contain only real roots. (Details of this procedure follow.)

Once re-partitioning has been completed, each partition has one real IRR (assuming it had one real
IRR in the feasible set). The investment type of the new partition is defined by the investment type of
the original partition with the real IRR. As with previous terminology, the relevant internal rate of
return is the real IRR that is contained in the same "new" partition as the MARR.

Step 4 from the original procedure (now Step 5) remains as before such that the relevant IRR,
investment type, and MARR are used to make the decisions.

It might be helpful to elaborate on how the re-partitioning scheme works. Start with the first partition
(-1, [[bar.i].sub.1]). If it contains a real IRR, proceed to the next partition. If it contains a complex IRR,
collapse the partition such that the "new" first partition is (-1, [[bar.i].sub.2]). Now repeat the
procedure. If the new partition contains a real IRR, proceed to the next partition ([[bar.i].sub.2],
[[bar.i].sub.3]). Otherwise, collapse the partition such that the new first partition is (-1, [[bar.i].sub.3]).
The procedure continues in this manner such that any original partition ([[bar.i].sub.j], [[bar.i].sub.j +
1]) with a complex root is collapsed into an original partition with a real root.

We illustrate the analysis involving complex roots with the following two examples.

Example 3. Our third example considers the cash flow stream (-1, 6, -11, 6.5) with its present worth
function defined in Figure 3.

[FIGURE 3 OMITTED]

1. The present worth function is

PW(i) = -1 + 6/[(1 + i).sup.1] + -11/[(1 + i).sup.2] + 6.5/[(1 + i).sup.3]

and the IRRs are [i.sup.*] = 2.19 and 4.0426 [+ or -] 0.2544i. (Do not confuse the use of the letter i,
which identifies a complex number with the interest rate.)
2. The first derivative is

dPW(i)/di = - 6/[(1 + i).sup.2] + 22/[(1 + i).sup.3] - 19.5/[(1 + i).sup.4]

and the minimum and maximum points are [bar.i] = 0.5 and 1.167.

3. Partition the project as: (-1, 0.5), (0.5, 1.167), and (1.167, [infinity]).

4. Due to the existence of complex roots in partitions one and two, we must re-partition the graph
such that each partition has one real root, or (-1, [infinity]). While the slope of the new partition does
not have a constant sign, we define it as loaning in this instance because that is the definition of the
original partition with the single real root. (We will address this issue again later.)

5. Since it is a loaning partition, we accept the project as the relevant IRR of 2.19 is greater than the
MARR 0.10.

Decisions for all possible MARRs are given in Table 3.

Example 4. The final example, with the present worth function illustrated in Figure 4, is defined by
the cash flow stream (0.25, -40, 65, -1, -25, -49.5, 40). We find that [i.sup.*] = -0.2616, 0.1319 [+ or -]
0.5393i, and 157.36. In this case, two of the four internal rates of return are complex. The optimal
points are [bar.i] = -0.1222, 0.5624, and 1.6592. We create the following partitions: (-1, -0.1222), (-
0.1222, 0.5624), (0.5624, 1.6592), and (1.6592, [infinity]) and define each as loaning, borrowing,
loaning and borrowing, respectively. As the complex roots are found in partitions 2 and 3, we re-
partition, creating the following new partitions: (-1, 1.6592), and (1.6592, [infinity]). The new
partitions are defined as loaning and borrowing, respectively, according to the original partitions with
real roots.

[FIGURE 4 OMITTED]
The MARR is located in partition one with [i.sup.*] = -0.2616. With the [IRR.sup.*] < MARR and the
partition defined as loaning, we reject the project. The results in Table 4 are consistent with present
worth.

In the case where no real internal rates of return exist, we cannot use this method of analysis to
determine project acceptability because there does not exist an IRR to compare to the MARR. (This
would also be a problem for traditional IRR analysis, which is a subset of this analysis.) Note that the
case in which there are no real IRRs means that the PW function never crosses the interest rate
axis. Thus, the PW is always positive or always negative, leading to a trivial decision in either case.

EQUIVALENCE TO PRESENT WORTH

The figures and tables in the previous section have illustrated that our method is consistent with
present worth for decision-making purposes. We formalize those concepts now.

Lemma 1: Under the assumption that at least one real IRR exists, there is at most one real root per
partition.

Proof: For the case of real IRRs, by definition, the slope between any two consecutive optima is
either positive or negative and does not change. Thus, the present worth function can equal zero at
most once in this interval, defining at most one IRR.

For the case including complex IRRs, by construction, each partition is defined by having one real
root.

Theorem 1: Project accept and reject decisions made with the relevant IRR are consistent with those
using present worth for any given MARR.

Proof: According to the present worth decision criterion, if the PW(MARR) > 0, then the project
should be accepted. Thus to prove consistency, if the PW(MARR) > 0, either:

[i.sup.*] < MARR and dPW(i)/di > 0 for i = MARR

or:

[i.sup.*] > MARR and dPW(i)/di < 0 for i = MARR

must be true.

Note that by our method, a partition is defined by either a positive or negative slope, and by Lemma
1 a partition has at most one real root.
By definition, PW([i.sup.*]) = 0. Assume dPW(i)/di > 0. For any i > [i.sup.*], the present worth
remains positive. Thus, if the [i.sup.*] < MARR, the PW(MARR) > 0. Assume dPW(i)/di < 0. For any i
< [i.sup.*], the present worth remains positive. Thus, if the [i.sup.*] > MARR, the PW(MARR) > 0.

According to the present worth decision criterion, if the PW(MARR) < 0, then the project should be
rejected. Thus to prove consistency, if the PW(MARR) < 0, either:

[i.sup.*] > MARR and dPW(i)/di > 0 for i = MARR

or:

[i.sup.*] < MARR and dPW(i)/di < 0 for i = MARR

must be true.

By definition PW([i.sup.*]) = 0. Assume dPW(i)/di > 0. For any i < [i.sup.*], the present worth remains
negative. Thus, if the [i.sup.*] > MARR, the PW(MARR) < 0. Assume dPW(i)/di < 0. For any i >
[i.sup.*], the present worth remains negative. Thus, if the [i.sup.*] < MARR, the PW(MARR) < 0.

Note that this argument also holds in the case of complex roots. Complex roots always occur in pairs
and thus, the present worth slope sign changes twice in their presence without crossing the x-axis (a
real root). Thus, the sign of the present worth slope in the partition preceding a complex root and the
sign of the slope in the partition after the second (companion) complex root are always the same.
Therefore, the present worth function does not change sign in the presence of complex roots and the
decision does not change when this area is "collapsed" in the re-partitioning procedure.

Thus, according to Theorem 1, the procedure described produces decisions that are consistent with
present worth.

INTERPRETING MULTIPLE IRRs

Now that the method of determining project acceptability in light of multiple internal rates of return
(assuming at least one is real) has been defined, the question remains as to whether multiple rates
of return have meaning. The popularity of the IRR as an investment decision criterion is clear when
there is one rate of return, as the rate truly defines the return earned (or interest paid) on an
investment. It can also be viewed as a measure of efficiency in this manner. However, these
interpretations are no longer clear with multiple rates of return.

It should be straightforward as to why multiple roots occur. They are the result of a change in the
interest rate causing individual cash flows' influences on present worth to change. Figure 5 illustrates
the present worth as a function of the interest rate for each individual cash flow from Example 1 with
flows (-1, 6, -11, 6). From this graph, we can better understand what is occurring over the interest
rate spectrum. The data for the graph is also given in Table 5 as the present worth curve is
extremely flat over the interesting range of interest rates, making the graph difficult to read.

[FIGURE 5 OMITTED]

We arbitrarily begin our analysis with a zero percent interest rate. At this rate, the sum of the inflows
and outflows negate each other, leading to a present worth of zero. Increasing the interest rate, the
influence of the final cash flow ($6) diminishes more quickly than the other cash flows, causing a
decreasing present worth (signaling an investment opportunity) that becomes negative. However, at
23.2%, the influence of the -$11 cash flow is overcome by the positive cash flows, and as the
interest rate continues to increase the present worth of the cash flow series increases (signaling a
loan opportunity). This continues until the rate of 143% is reached, at which time the influence of the
$6 cash flow at time one is overcome and the negative time zero cash flow dominates, as the
present worth decreases, approaching the investment cost of -$1 as the interest rate goes to infinity.

Walking through this example reiterates the fact that the cash flows cannot be defined as borrowing
or loaning opportunities unless the interest rate is specified, as it defines the influence of each
individual cash flow on the slope of the present worth function. In this example, the cash flows truly
define three different opportunities, depending on the discount rate used by the evaluator. For
example, if a company uses a rate of 15%, then they would reject this as an investment opportunity.
If a different company had a discount rate of 25%, they would reject the project as a loan
opportunity.

In the described method, we partitioned the present worth function according to different interest
rates. In each region, the type of investment is fixed, as the slope is either increasing or decreasing.
Thus, each partition defines an investment (loaning or borrowing) to be analyzed. While we
traditionally think that a cash flow series defines an investment (or borrowing) opportunity, it is truly
the cash flows and the interest rate that define the opportunity.

If an investment cannot be defined exogenously from the interest rate, then a series of cash flows
may define numerous investments. Given a cash flow series and a MARR, the relevant rate of return
defined in this article is a valid rate of return for analysis and can be interpreted much in the same
way that a unique IRR is analyzed. This recognition of a MARR to identify the relevant IRR can be
avoided in the case of a unique, real IRR, because it is the relevant IRR, using our terminology, for
all possible MARRs. Despite this fact, the IRR still requires the definition of a MARR for project
accept/reject decisions. This is because the IRR is a relative measure of worth, not an absolute
measure of worth, such as present worth. The difference with multiple rates of return is that one
cannot find the internal rate of return and then compare it to the discount rate. Rather, one must
specify the discount rate, identify the relevant rate of return, and then make a comparison.

This may seem like a subtle difference, but it may have far-reaching consequences. Consider the
approach for identifying the MARR (in constrained capital budgeting) in which projects are ranked
according to their IRRs and the MARR is identified as the rate at which projects can no longer be
funded due to resource limitations (assuming projects are accepted in ranked order). Following our
reasoning, the MARR must be identified before identifying the relevant rate of return. Thus, any
method that presumes to use the internal rate of return without knowledge of the MARR would
appear to be infeasible. This, again, is due to the nature of the IRR being a relative measure of
worth, rather than an absolute measure, as present worth. Fortunately, this "issue" is avoided for the
case of a unique IRR because, as noted earlier, it is the relevant IRR for all possible MARR values.
It should, however, give one pause when applying this method.

As noted by Hazen (2003), it is difficult, if not impossible, to interpret complex internal rates of return.
In our partitioning scheme, they are removed from analysis and we assume that a project's status
(loaning or borrowing) does not change in the new partition. We can say this because the presence
of complex roots means the slope of the present worth has changed, but not significantly enough to
produce a real root (cross the x-axis). Rather, by definition of a complex root, the slope must change
again before the x-axis is crossed. Unfortunately, while our method of collapsing partitions allows for
correct analysis in the presence of complex roots, it muddles our definition of a project being loaning
or borrowing according to the slope of the present worth. This might signal that complex roots do
have meaning, although we do not have an interpretation at this time.

CONCLUSIONS AND FUTURE RESEARCH

In this article, we present a method for determining project acceptability when multiple IRRs are
present. Like most other methods, this technique is consistent with present worth. However, unlike
other methods, this method considers the MARR when determining the relevant IRR, which
determines project suitability. The method is illustrated with four different examples and shown to be
viable for any problem in which there is at least one real root. When complex roots are encountered,
only the real roots are used for project acceptability decisions.

We use the term "relevant IRR" in this article as we identify which rate, from the set of real IRRs, is
relevant and should be used in subsequent analysis. As we require an external rate to define the
relevant IRR, a reviewer correctly noted that the relevant IRR is no longer "internal." We
acknowledge that here but keep the name, stressing that this procedure does not define a new rate
of return, but merely chooses one from the set of IRRs.
We also attempt to shed light on the meaning of multiple IRRs. We argue that a series of cash flows
does not define an investment opportunity (loaning or borrowing). Rather, this cannot be determined
without a discount rate. As the case of having a single IRR is merely a special case of ours, it would
appear to discourage the use of IRRs for determining the MARR, as the relevant IRR cannot be
determined exogenously from the MARR. This problem is mitigated in the case of a unique IRR, as it
is the relevant rate of return for all possible MARRs.

While the proposed method is consistent with present worth when at least one real root is present,
we echo the sentiments of previous scholars that advocate the use of present worth in these
situations (multiple IRRs). Identifying the relevant IRR is not complicated, but it is much more
involved than identifying the present worth of the cash flows given the discount rate. The goal of this
article is to shed more light on the meaning of multiple IRRs and their relation to loan and investment
opportunities. We also believe that this information can be useful for staunch advocates of the IRR.

As for future research, it would be interesting to more formally tie this method to the methods of
Hazen (2003) and Teichroew, Robichek, and Montalbano (1965). Perhaps the link may lie in
investment balances, but this will not be trivial as the method here differentiates a project according
to the discount rate, not time. Finally, it would be interesting to attribute some formal meaning to
complex IRRs because, as noted earlier, they cause interpretation problems with respect to the type
of investment being analyzed.

ACKNOWLEDGMENT
This research was supported in part by the National Science Foundation grant number DMI-
9984891. We would like to thank two anonymous referees for their constructive comments which
improved the readability of the manuscript.

REFERENCES

[1] Athanasopoulos, P.J., "A note on the modied internal rate of return and investment criterion." The
Engineering Economist, Vol. 23, No. 2, 1978, pp. 131-133.

[2] Baldwin, R.H., "How to assess investment proposals," Harvard Business Review, Vol. 27, No. 3,
1959, pp. 98-104.

[3] Bernhard, R.H., "Modied rates of return for investment project evaluation--A comparison and
critique," The Engineering Economist, Vol. 24, No. 3, 1979, 161-167.

[4] Bierman, Jr. H. and S. Smidt, The capital budgeting decision (8th ed.). New York: MacMillan,
1993.

[5] Bussey, L.E. and T.G. Eschenbach, The economic analysis of industrial projects (2nd ed.). New
York: Prentice-Hall, 1992.

[6] Cannaday, R.E., P.F. Colwell, and H. Paley, "Relevant and irrelevant internal rates of return," The
Engineering Economist, Vol. 32, 1986, pp. 17-38.

[7] Hajdasinski, M.M. "On relevant and irrelevant internal rates of return," The Engineering
Economist, Vol. 32, 1987, pp. 347-353.

[8] Hazen, G.B., "A new perspective on multiple internal rates of return," The Engineering Economist,
Vol. 48, 2003, pp. 31-51.

[9] Lin, S.A.Y., "The modifed internal rate of return and investment criterion," The Engineering
Economist, Vol. 21, No. 4, 1976, pp. 237-247.

[10] Lorie, J.H. and L.J. Savage, "Three problems in rationing capital," The Journal of Business, Vol.
28, No. 4, 1955, pp. 228-239.

[11] Maplesoft, Maple 9.0. Waterloo, Canada: Maplesoft, 2003.

[12] Solomon, E. "The arithmetic of capital budgeting decisions," Journal of Business, Vol. 29, 1956,
pp. 124-129.

[13] Teichroew, D., A.A. Robichek, and M. Montalbano, "An analysis of criteria for investment and
nancing decisions under certainty," Management Science, Vol. 13, No. 3, 1965, pp. 150-179.

Joseph C. Hartman

Ingrid C. Schafrick

Department of Industrial and Systems Engineering, Lehigh University, Bethlehem, Pennsylvania,

USA
JOSEPH C. HARTMAN is an associate professor in the Department of Industrial and Systems
Engineering at Lehigh University. He received his Ph.D. (1996) and M.S. (1994) in Industrial
Engineering from the Georgia Institute of Technology and B.S. in General Engineering from the
University of Illinois at Urbana-Champaign (1992). He is an active member of ASEE, IIE, and
INFORMS and currently serves as an editor of The Engineering Economist. He won the 2000
Eugene L. Grant Award from ASEE.

INGRID SCHAFRICK is a Corporate Value Consultant for Standard and Poors in New York City.
She received her B.S. in Industrial Engineering in 2002 from Lehigh University. After achieving Alpha
Pi Mu and Tau Beta Pi honors, she was named a Presidential Scholar to pursue her M.S. in
Industrial Engineering from Lehigh University (2003). She has previously worked for IBM and Lutron
Electronics.

Address correspondence to Joseph C. Hartman, Department of Industrial and Systems Engineering,

Lehigh University, Bethlehem, PA 18015. E-mail: jch6@lehigh.edu

TABLE 1. Investment Decisions for All Possible MARRs for Example 1.

Partition
investment Relevant Partition
rate IRR type MARR Decision

-1 < i [??] 0 Loaning -1 < MARR < 0 Accept

0.232 MARR = 0 Indifferent
0 < MARR < 0.232 Reject

0.232 [??] i 1 Borrowing 0.232 [??] MARR < 1 Reject

[??] 1.43 MARR = 1 Indifferent
1 < MARR [??] 1.43 Accept

i [??] 1.43 2 Loaning 1.43 [??] MARR < 2 Accept

MARR = 2 Indifferent
MARR > 2 Reject

TABLE 2. Investment Decisions for All Possible MARRs for Example 2.

Partition
interest Relevant Partition
rate IRR type MARR Decision

-1 < i [??] 1 1 Borrowing -1 < MARR < 1 Reject

MARR = 1 Indifferent

i [??] 1 1 Loaning MARR = 1 Indifferent

MARR > 1 Reject

TABLE 3. Investment Decisions for All Possible MARRs for Example 3.

Partition
interest Relevant Partition
rate IRR type MARR Decision

i > -1 2.19 Loaning -1 < MARR < 2.19 Accept

MARR = 2.19 Indifferent
MARR > 2.19 Reject
TABLE 4. Investment Decisions for All Possible MARRs for Example 4.

Partition
interest Relevant Partition
rate IRR type MARR Decision

-i < i [??] -0.2616 Loaning -1 < MARR < -0.2616 Accept

1.6592 MARR = -0.2616 Indifferent
-0.2616 < MARR Reject
< 1.6592

i > 1.6592 157.36 Borrowing 1.6592 [??] MARR Reject

< 157.37
MARR = 157.37 Indifferent
MARR > 157.36 Accept

TABLE 5. Present Worth for Each Individual Cash Flow for Example 1.

i % -1.00 6/[(1+i).sup.1] -11/[(1+i).sup.2]

-20 -1.00 7.50 -17.19

-10 -1.00 6.67 -13.58
0 -1.00 6.00 -11.00
10 -1.00 5.45 -9.09
20 -1.00 5.00 -7.64
30 -1.00 4.62 -6.51
40 -1.00 4.29 -5.61
50 -1.00 4.00 -4.89
60 -1.00 3.75 -4.30
70 -1.00 3.53 -3.81
80 -1.00 3.33 -3.40
90 -1.00 3.16 -3.05
100 -1.00 3.00 -2.75
110 -1.00 2.86 -2.49
120 -1.00 2.73 -2.27
130 -1.00 2.61 -2.08
140 -1.00 2.50 -1.91
150 -1.00 2.40 -1.76
160 -1.00 2.31 -1.63
170 -1.00 2.22 -1.51
180 -1.00 2.14 -1.40
190 -1.00 2.07 -1.31
200 -1.00 2.00 -1.22
210 -1.00 1.94 -1.14
220 -1.00 1.88 -1.07
230 -1.00 1.82 -1.01
240 -1.00 1.76 -0.95
250 -1.00 1.71 -0.90
260 -1.00 1.67 -0.85
270 -1.00 1.62 -0.80
280 -1.00 1.58 -0.76
290 -1.00 1.54 -0.72
300 -1.00 1.50 -0.69

i % 6/[(1+i).sup.3] PW(i) dPW(i)/di

-20 11.72 1.03 -10.3516
-10 8.23 0.32 -4.6639
0 6.00 0.00 -2.0000
10 4.51 -0.13 -0.7240
20 3.47 -0.17 -0.1157
30 2.73 -0.16 0.1611
40 2.19 -0.14 0.2707
50 1.78 -0.11 0.2963
60 1.46 -0.08 0.2808
70 1.22 -0.06 0.2466
80 1.03 -0.03 0.2058
90 0.87 -0.01 0.1642
100 0.75 0.00 0.1250
110 0.65 0.01 0.0895
120 0.56 0.02 0.0581
130 0.49 0.02 0.0307
140 0.43 0.02 0.0072
150 0.38 0.02 -0.0128
160 0.34 0.02 -0.0298
170 0.30 0.02 -0.0440
180 0.27 0.01 -0.0560
190 0.25 0.01 -0.0659
200 0.22 0.00 -0.0741
210 0.20 -0.01 -0.0808
220 0.18 -0.02 -0.0862
230 0.17 -0.02 -0.0906
240 0.15 -0.03 -0.0940
250 0.14 -0.04 -0.0966
260 0.13 -0.05 -0.0986
270 0.12 -0.06 -0.1000
280 0.11 -0.07 -0.1009
290 0.10 -0.08 -0.1014
300 0.09 -0.09 -0.1016

Hartman, Joseph C.^Schafrick, Ingrid C.