Average rates of return, working capital, and NPV-consistency in project appraisal: A sensitivity analysis approach

Magni, Carlo Alberto and Marchioni, Andrea (2020): Average rates of return, working capital, and NPV-consistency in project appraisal: A sensitivity analysis approach. Forthcoming in: International Journal of Production Economics (forthcoming)

Abstract

In project appraisal under uncertainty, the economic reliability of a measure of financial efficiency depends on its strong NPV-consistency, meaning that the performance metric (i) supplies the same recommendation in accept-reject decisions as the NPV, (ii) ranks competing projects in the same way as the NPV, (iii) has the same sensitivity to perturbations in the input data as the NPV. In real-life projects, financial efficiency is greatly affected by the management of the working capital. Using a sensitivity analysis approach and taking into explicit account the role of working capital, we show that the average return on investment (ROI) is not strongly NPV-consistent in accept-reject decisions if the working capital is uncertain and changes under changes in revenues and costs. Also, it is not strongly NPV-consistent in project ranking. We also show that the internal rate of return (IRR) is not strongly NPV-consistent and economic analysis may even turn out to be impossible, owing to possible nonexistence and multiplicity caused by perturbations in the input data, as well as to possible shifts in the financial meaning of IRR under changes in the project’s value drivers. We introduce the straight-line rate of return (SLRR), based on the notion of average rate of change, which overcomes all the problems encountered by average ROI and IRR: It always exists, is unique, strongly NPV-consistent for both accept-reject decisions and project ranking, and has an unambiguous financial nature.

• Item Type: MPRA Paper
• Language: English
• Keywords: Finance, project evaluation, working capital, ROI, IRR, sensitivity analysis, net present value, straight-line, project ranking
• Subjects: C - Mathematical and Quantitative Methods > C4 - Econometric and Statistical Methods: Special Topics; C - Mathematical and Quantitative Methods > C4 - Econometric and Statistical Methods: Special Topics > C44 - Operations Research ; Statistical Decision Theory; D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D81 - Criteria for Decision-Making under Risk and Uncertainty; D - Microeconomics > D9 - Intertemporal Choice > D92 - Intertemporal Firm Choice, Investment, Capacity, and Financing; G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; G - Financial Economics > G3 - Corporate Finance and Governance > G31 - Capital Budgeting ; Fixed Investment and Inventory Studies ; Capacity; M - Business Administration and Business Economics ; Marketing ; Accounting ; Personnel Economics > M4 - Accounting and Auditing > M41 - Accounting

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