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On the Net Present Value Rule for Educational Investments

Hansen (1963), in his study on the profitability of investment in education, has noted that the present value of lifetime income is deficient as an investment criterion because it omits the direct educational costs from the benefit-cost calculations. He also demonstrates that the ranking of educational investments is sensitive to the choice of the discount rate used in calculating the present value estimates. He argues that the internal rate of return corrects the above deficiencies and, therefore, is a superior tool for analysis. Similar arguments in favor of the internal rate of return (IROR) have been voiced by other authors.1 Unfortunately, much of the argument against the present value rule is based on false premises. First, it is obviously not the present value of gross lifetime income which should be compared with the IROR; rather, the present value of lifetime income net of costs is the proper rule for comparison. Second, the fact that the net present value may be sensitive to the rate of discount is not a deficiency but, rather, an important asset which ought not to be neglected. Further, when investments are sequentially interdependent or mutually exclusive, as they are in education, the IROR rule will frequently be unreliable. It has been argued that the net present value rule is not applicable unless and until the "true" and appropriate rate of discount is known. Since there is no agreement on which rate of discount is "proper" for public or private investment decisions, it appears that the net present value rule is highly unsatisfactory in actual applications. The IROR, on the other hand, can be computed without any reference to a discount rate, and thus it appears to be a great deal more useful for application of public or private investment decisions. This argument, however, can hardly be justified on either theoretical grounds or computational convenience. First, the IROR rule states that the computed internal rate of return should be compared with the chosen discount rate (Prest and Turvey 1965, p. 703). While it is true that one could compute the IROR without having to make a decision on the "proper" discount rate, once a decision on the profitability of the invest-