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IRR and NPV in Capital Budgeting: Uses, Limits, and Practice

Article Quant Q&A · Author: Patrick
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Summary

The document reviews the internal rate of return (IRR) and net present value (NPV) as capital budgeting measures, drawing on reported survey results and practitioner accounts. IRR offers a compact rate that managers may find easy to compare with a financing cost or hurdle rate. But unconventional cash flow patterns can produce multiple IRRs, and spreadsheet root finding may return different solutions depending on its starting guess. The discussion also questions the assumption that interim cash flows can be reinvested at the IRR. NPV instead discounts cash flows to present value, potentially using different rates for different risks, but requires explicit choices about those rates.

Practitioners describe varied use across company sizes and project types: some rely on IRR for simplicity, while others use payback or NPV, and managers may select whichever measure supports a desired decision. The accounts are personal perspectives rather than a representative current survey, and one respondent disputes common criticisms of IRR. The document therefore illustrates both the analytical tradeoffs and the organizational incentives that shape metric choice, without establishing an industry-wide consensus.

Key ideas

  • IRR gives managers a single rate that can be easy to compare with a hurdle or financing cost.
  • Nonstandard cash flow patterns can produce multiple IRRs, and numerical methods may select different roots.
  • NPV can accommodate cash flows with different discount rates but requires choosing those rates.
  • Practitioner accounts describe IRR use as varying by company size, project type, and management preference.
  • Managers may choose the evaluation measure that presents a favored project most attractively.

Tags

StatisticsRisk managementPortfolio construction
Full text
# Volatility time weights calculation


# Volatility time weights calculation












I. Clark introduces the concept of volatility time in Foreign Exchange Option Pricing under which the implied volatility should be interpolated in time with the formula below:

where w is a weight function. He assumes that w is equal to 1 for any business day (Monday to Friday) and 0 for weekends. I'm wondering how could I get a more accurate estimation of w for each day based on historical data?

## Answer by Valometrics.com (score 1)

https://quant.stackexchange.com/a/50850

As explained in the chapter 4.4 of I. Clark, you can estimate the weights by using the typical trading volumes. You can give more weight for dates with bigger trading volume which is logical.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.