Internal Rate of Return analysis is the most commonly used method for investment selection and performance measurement. It measures the expected return from an investment over a specific holding period. Another way to put it is that IRR measures the yield on each dollar invested for as long as it remains in an investment. This is an important distinction because it underlies the limitations associated with using IRR to compare investment alternatives.
The Capital Accumulation Process mitigates the limitations associated with IRR and thus provides a more comprehensive analysis to choose between investment alternatives. The process has 4 steps:
- Adjust each investment alternative to eliminate all negative cash flows.
- Reinvest all positive cash flows to the end of the holding period using an appropriate discount/reinvestment rate.
- Adjust between the investment alternatives for any size disparity between the initial investment amounts.
- Adjust for any time disparity between the holding periods using an appropriate discount/reinvestment rate.
There are times when IRR is inadequate to identify the preferred investment alternative; making it necessary to use the capital accumulation process. This method distinguishes between multiple investment alternatives to show which leads to greater capital accumulation at the end of the holding period and is thus the superior investment.