Capital Budgeting: The Role of Cost Allocations

Gow, Ian D.; Reichelstein, Stefan

doi:10.1007/978-3-540-69995-8_19

Cited by 2 publications

(1 citation statement)

References 16 publications

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“…Net-present-value consistency of a performance metric means that the decisions recommended by the metric are the same as the ones recommended by the NPV criterion. The literature on NPV-consistent (or NPV-compatible) measures is enormous and spans over several decades (e.g., see Hajdasinski 1995, 1997, Hartman 2000, Hartman and Schafrick 2004, Pfeiffer 2004, Gow and Reichelstein 2007, Lindblom and Sjögren 2009, Chiang, Cheng and Lam 2010 Padilla and Jadotte 2013).…”

Section: Introductionmentioning

confidence: 99%

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

Magni

Marchioni

2020

International Journal of Production Economics

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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.

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Section: Introductionmentioning

confidence: 99%

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

Magni

Marchioni

2020

International Journal of Production Economics

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Capital depreciation and the underdetermination of rate of return: A unifying perspective

Magni

2016

Journal of Mathematical Economics

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Abstract. This paper shows that the notion of rate of return is best understood through the lens of the average-internal-rate-of-return (AIRR) model, first introduced in Magni (2010a). It is an NPVconsistent approach based on a coherent definition of rate of return and on the notion of Chisini mean, it is capable of solving the conundrums originated by the rate-of-return notion and represents a unifying theoretical paradigm under which every existing measure of wealth creation can be subsumed. We show that a rate of return is underdetermined by the project's cash-flow stream; in particular, a unique return function (not a unique rate of return) exists for every project which maps depreciation classes into rates of return. The various shapes a rate of return can take on (internal rate of return, average accounting rate of return, modified internal rate of return etc.) derive from the (implicit or explicit) selection of different depreciation patterns. To single out the appropriate rate of return for a project, auxiliary assumptions are needed regarding the project's capital depreciation. This involves value judgment. On one side, this finding opens terrain for a capital valuation theory yet to be developed; on the other side, it triggers the creation of a toolkit of domainspecific and purpose-specific metrics that can be used, jointly or in isolation, for analyzing the economic profitability of a given project. We also show that the AIRR perspective has a high explanatory power that enables connecting seemingly unrelated notions and linking various disciplines such as economics, finance, and accounting. Some guidelines for practitioners are also provided.

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Capital Budgeting: The Role of Cost Allocations

Cited by 2 publications

References 16 publications

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

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

Capital depreciation and the underdetermination of rate of return: A unifying perspective

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