Sensitivity Analysis and Investment Decisions: NPV-Consistency of Rates of Return

Abstract

Investment decisions may be evaluated via several different metrics/criteria, which are functions of a vector of value drivers. The economic significance and the reliability of a metric depend on its consistency with the Net Present Value (NPV), which signals shareholder value creation. Traditionally, a metric is NPV-consistent if it correctly signals value creation. This paper makes use of sensitivity analysis for measuring consistency between rates of return and NPV. In particular, it introduces a new, stronger definition of NPV-consistency that takes into account the influence of value drivers on the metric output. A metric is strongly NPV-consistent if (it signals value creation and) the ranking of the value drivers in terms of impact on the output is the same as that provided by the NPV. We show that IRR is not strongly consistent and that its degree of inconsistency is not negligible via Spearman's (1904) correlation coefficient and Iman and Conover's (1987) top-down coefficient. We introduce a new metric, called straight-line AIRR, belonging to the class of AIRRs (Magni 2010, 2013), which is associated with straight-line capital depreciation. This new metric enjoys strong NPV-consistency under several (possibly all) methods of sensitivity analysis.