Question

A study done by Dr. graham and Harvey found that a sizable minority of firms (25%) in their study do not use the NPY rule. In addition , about 50% of firms surveyed used the payback rule. Also, most firms used both the NVP and the IRR rules. Why do firms use rules other than NVP since they can lean to erroneous decisions ?

Answer 1

The survey results could be misleading. CFOs that are using the IRR as a sensitivity measure along with the NPV could have selected the IRR and NPV box on the survey. Bycalculating the IRR and using the NPV rule they could have been under the impression they were using both rules. Some replies stated they only used the IRR rule. A reason given for using the IRR rule only is that you do not need to know the opportunity cost of capital to calculate the IRR. The IRR does not depend on the cost of capital. It may not benecessary to know the cost of

capital to calculate the IRR. However, the cost of capital needs to be know when applying the

IRR rule. Therefore, the opportunity cost is as pertinent to the IRR rule as it is to the NPV rule.

Some firms use the IRR rule only because the IRR tallies up the desirability of investment

opportunity in a single number without running the numbers to have to make an assumption

about the cost of capital. The NPV profile has the advantage of providing more information

and being reliable.