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.
Highlights
In capital budgeting many different criteria are used for evaluating a project and making decisions
We show that Internal Rate of Return (IRR) is not strongly Net Present Value (NPV)-consistent and show that its degree of inconsistency is not negligible by means of both 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
Summary
In capital budgeting many different criteria are used for evaluating a project and making decisions. This paper applies SA to investment decisions In this context, an objective function is a metric depending on a set of value drivers that aims at measuring the economic profitability (i.e., value created) of the project. We compare NPV, IRR and SL-AIRR and analyze their reciprocal coherence To this end, we give a new definition of NPV-consistency (strong coherence), according to which a metric is NPV-consistent under a given SA technique if it is NPVconsistent in the traditional sense and, in addition, the ranking of the project’s value drivers (in terms of influence on the output) is the same. AIRR is a more reliable measure of worth, which can coherently be associated with NPV in investment evaluation and decisions.
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