On the bias of yield-based capital budgeting methods

Economics Bulletin, 2008, vol. 7, issue 9, pages 1-8

Abstract: The aim of this paper is twofold. First, we present a new capital budgeting method, called the real rate of return (RRR), which has been developed for solving the inconsistency of the modified internal rate of return (MIRR) with shareholders' wealth maximization when costs of capital differ between projects. After surveying the merits of this method over the MIRR, we focus our attention on another interesting feature of the RRR when cash flows are uncertain. We compare the RRR bias with the MIRR bias and demonstrate that the RRR bias is inferior to the MIRR bias. This theoretical finding confirms once again that the RRR is a better capital budgeting method than the MIRR. Knowing that managers exhibit in practice a large preference for comparing the merits of projects with rates of return, this simple and flexible yield-based capital budgeting method has all the qualities to be accepted in practice.

Keywords: Capital budgeting; modified internal rate of return; real rate of return; bias. (search for similar items in EconPapers)
JEL-codes: G3 (search for similar items in EconPapers)
Date: 2008-05-24
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