Academicians have demonstrated the superiority of the Net Present Value (NPV) method for capital budgeting decisions for the value maximizer. Unfortunately, practitioners do not exhibit the same fervor for theoretical purity that academics do. Specifically, numerous surveys of capital budgeting practices show that the most commonly used discounted cashflow (DCF) method among practitioners is the Internal Rate of Return (IRR). Theorists have shown that the IRR is an accurate method for typical capital budgeting cases, giving proper accept or reject solutions; nevertheless, in some cases the IRR solution is inferior to the NPV solution. Thus, theorists favor the NPV in research and class endeavors. Yet, decision makers tend to ignore the plea of NPV's higher level o f "rigor" in favor of the IRR's "more intuitive appeal."Because o f the exceptional cases and perhaps to bring academicians and practitioners closer, many have undertaken to improve the IRR by creating various DCF methods that give answers in the form of yields. Not all of these creations have met the demands of logical consistency; not all have had clear focus on what one must do to make a rational capital budgeting decision; and most have too much of an ad hoc flair to be considered legitimate pedagogically. Many of these new methods are not in the finance literature and thus may have escaped notice; therefore, a critical review of some of these methods is the second section of the paper.The criticisms of existing yield-based methods are based on a theoretical framework for NPV, set up in the paper's first section as a standard for comparison of other models presented. Then assumptions are relaxed to accommodate pragmatic decision-making. This is done to demonstrate how NPV and yield-based methods deal with the changed environment. The third section is the paper's primary purpose. It sets forth eight criteria essential for a yield-based DCF methods to be a valid substitute for NPV. These criteria require that the yield-based method: . 4. 5. 6.7. 8.gives the same accept/reject decision as NPV for every project; maintains risk-equivalence with the firm's typical operations so that it may be compared to the marginal cost of capital; is consistent with the idea that in the long run the marginal return on projects approaches equilibrium with the marginal cost of capital; includes the idea that capital funds are different from operational cashfl ows ; gives a unique solution for every project; ranks projects of unequal size in the same order as NPV; ranks projects having time disparity in the same order as NPV; and ranks projects having unequal lives in the same order as NPV.Finally, the paper defines a yield-based method that meets seven of these criteria. Formal proofs demonstrating the consistency with each criterion are given where necessary. The paper demonstrates the logical inconsistency and conceptual impossibility of any yield-based method discriminating among projects of different sizes.
This article discusses and critiques yield‐based capital budgeting techniques that have arisen over the past 30 years. Some have theoretical inconsistencies, while some work well only for certain kinds of problems. A new method, the marginal return on invested capital, is presented. The method's application is general; it gives accept/reject signals and rankings consistent with the net present value method.
Like plants and animals which evolve in response to a changing environment, investment methods show remarkable mutability. One of the more resilient techniques is riding the yield curve -the practice of purchasing U.S. treasury bills of maturities longer than a planned holding period and selling them prior to maturity. Several authors [2, 15,161 argue that 'this technique allows investors to capture higher yields without facing excessive risk. This paper investigates that claim.We begin with a brief theoretical discussion which distinguishes two classes of investors differing in their assessment of the risks of riding the yield curve. T o the marginal investor, the risk premium required for mismatching his holding period and the maturity of securities purchased curve is the term premium imbedded in the equilibrium term structure of interest rates. Intramarginal investors, on the other hand, are willing to accept smaller risk premiums. Our empirical tests measure the incremental return earned by riding the yield curve as opposed to matching maturities and assessing the desirability of riding the yield curve for both classes of investors.' TheoryIn the context of modern financial theory, an active investment strategy is desirable only if it produces an expected return exceeding that of an alternative passive approach with lower risk. Riding the yield curve is an active strategy in which the investor takes on risk by mismatching his holding period and the maturity of the Treasury bill purchased. A corresponding passive strategy involves matching the maturity purchased with the investor's holding period. Because maturity and duration are the same for pure-discount securities like Treasury bills, the maturity-matching approach is an immunized strategy and is riskless in the sense that the future nominal proceeds are known with certainty.The nominal proceeds (and nominal rate of return) are protected against interest-rate risk, but the real rate of return is not protected against unanticipated inflation. Other strategies (for example, rolling over short-term bills) subject an investor to interest-rate risk but may lessen the risk arising from unanticipated inflation. In this paper, in the duration literature, and in the overwhelming majority of research in finance, the focus is on nominal
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