Evaluating multiple sign change and mixed projects using the return on invested capital model

Abstract

While the NPV and IRR models usually lead to correct and intuitively clear long-term investment decisions, there is a class of ‘mixed’ projects with both investment and financing phases in which the possibility of multiple rates of return and intuitive inconsistencies can arise. Because of the increased frequency of leveraged leases, these issues have taken on added importance. Practitioners are known to prefer a rate of return measure (usually the IRR) to the NPV model. However, the IRR model can result in analytical problems (e.g. multiple IRRs, no IRR, etc.) when used to evaluate the above mentioned types of projects. This paper illustrates the use of the return on invested capital (RIC) model, a generalization of the IRR, for evaluating investment projects. The RIC solves a number of analytical difficulties which can arise when using the IRR model. Seven examples, suitable for classroom use, are presented to illustrate the usefulness of the RIC model.