Internal Rate of Return

Internal rate of return can also be used to rank alternative cash flow streams. The rule is simply this: the higher the internal rate of return, the more desirable the investment. However, a potential investment, or project, is presumably not worth considering unless its internal rate of return is greater than the prevailing interest rate, If the internal rate of return is greater than the prevailing interest rate, the investment is considered better than what is available externally in the financial market.

Example 2.5 (When to cut a tree, continued) Let us use the internal rate of return method to evaluate the two tree harvesting proposals considered in Example 2 4 The equations for the internal rate of return in the two cases are

As usual, c = 1/(1 -f-r). These have the following solutions:

In other words, for (a), cut early, the internal rate of return is 100%, whereas for (b) it is about 70%. Hence under the internal rate of return criterion, the best alternative is («) Note that this is opposite to the conclusion obtained from the net present value criterion

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