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Sensitivity analysis and investment decisions: NPV-consistency of rates of return

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  • Andrea Marchiioni
  • Carlo Alberto Magni

Abstract

Investment decisions may be evaluated via several different metrics, which are functions of a vector of value drivers. The economic significance and 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 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 Internal Rate of Return (IRR) is not strongly 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. This new metric enjoys strong NPV-consistency under several (possibly all) methods of sensitivity analysis.

Suggested Citation

  • Andrea Marchiioni & Carlo Alberto Magni, 2016. "Sensitivity analysis and investment decisions: NPV-consistency of rates of return," Department of Economics 0089, University of Modena and Reggio E., Faculty of Economics "Marco Biagi".
    • Handle: RePEc:mod:depeco:0089
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    References listed on IDEAS

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    1. Borgonovo, E. & Gatti, S. & Peccati, L., 2010. "What drives value creation in investment projects? An application of sensitivity analysis to project finance transactions," European Journal of Operational Research, Elsevier, vol. 205(1), pages 227-236, August.
    2. Carlo Alberto Magni, 2010. "Average internal rate of return and investment decisions: A new perspective," PROYECCIONES FINANCIERAS Y VALORACION 006653, MASTER CONSULTORES.
    3. Joy, O Maurice & Bradley, Jerry O, 1973. "A Note on Sensitivity Analysis of Rates of Return," Journal of Finance, American Finance Association, vol. 28(5), pages 1255-1261, December.
    4. E. Borgonovo & S. Tarantola & E. Plischke & M. D. Morris, 2014. "Transformations and invariance in the sensitivity analysis of computer experiments," Journal of the Royal Statistical Society Series B, Royal Statistical Society, vol. 76(5), pages 925-947, November.
    5. Borgonovo, E. & Peccati, L., 2006. "Uncertainty and global sensitivity analysis in the evaluation of investment projects," International Journal of Production Economics, Elsevier, vol. 104(1), pages 62-73, November.
    6. Carlo Magni, 2013. "The Internal Rate of Return Approach and the AIRR Paradigm: A Refutation and a Corroboration," The Engineering Economist, Taylor & Francis Journals, vol. 58(2), pages 73-111.
    7. Carlo Alberto Magni, 2010. "Average internal rate of return and investment decisions: A new perspective," Proyecciones Financieras y Valoración 6653, Master Consultores.
    8. Borgonovo, E. & Peccati, L., 2004. "Sensitivity analysis in investment project evaluation," International Journal of Production Economics, Elsevier, vol. 90(1), pages 17-25, July.
    9. Borgonovo, Emanuele & Plischke, Elmar, 2016. "Sensitivity analysis: A review of recent advances," European Journal of Operational Research, Elsevier, vol. 248(3), pages 869-887.
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    Cited by:

    1. Magni, Carlo Alberto, 2016. "Capital depreciation and the underdetermination of rate of return: A unifying perspective," Journal of Mathematical Economics, Elsevier, vol. 67(C), pages 54-79.

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    More about this item

    Keywords

    Sensitivity analysis; investment decisions; NPV; consistency; straight-line AIRR; IRR.;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • Q28 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Renewable Resources and Conservation - - - Government Policy

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