The Generalized Rate of Return

Investment analysis, both for purposes of capital expenditures and for financial investments, is based on an evaluation of cash flows. This evaluation involves the application of interest rates in order to determine whether a given option–a series of cash flows–is profitable or not. For numerous reasons, primarily that of simplicity, it has been traditional to assume that the rates of interest used to measure the worth of an investment are constant. With this assumption it is possible to equate the two familiar investment criteria when investments are independent and outlays are not subject to expenditure constraints, i.e., when capital markets are taken to be perfect in the usual sense. An investment is profitable if its net present value is positive when discounting of cash flows uses the (assumed constant) cost of capital, or if its (assumed unique) internal rate of return is greater than the cost of capital. Equivalence of these two criteria is historically most frequently identified with Irving Fisher [3, 4], and his two-period analysis, portrayed graphically, is generally utilized to establish the correctness of the equivalence of the criteria.