Average Rates of Return, Working Capital, and NPV-Consistency in Project Appraisal: A Sensitivity Analysis Approach

International Journal of Production Economics, 229 (November), 107769, 2020

38 Pages Posted: 26 May 2020 Last revised: 9 Nov 2020

See all articles by Carlo Alberto Magni

Carlo Alberto Magni

Università degli studi di Modena e Reggio Emilia (UNIMORE) - School of Doctorate E4E (Engineering for Economics-Economics for Engineering)

Andrea Marchioni

Università degli studi della Tuscia - Department of Economics, Engineering, Society and Business, University of Tuscia, Via del Paradiso 47, 01100 Viterbo, Italy

Date Written: April 27, 2020

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.

Keywords: Finance, project evaluation, working capital, ROI, IRR, sensitivity analysis, net present value, straight-line, project ranking

JEL Classification: C4, C44, D81, M41, G31, G12, D92

Suggested Citation

Magni, Carlo Alberto and Marchioni, Andrea, Average Rates of Return, Working Capital, and NPV-Consistency in Project Appraisal: A Sensitivity Analysis Approach (April 27, 2020). International Journal of Production Economics, 229 (November), 107769, 2020, Available at SSRN: https://ssrn.com/abstract=3587029

Carlo Alberto Magni (Contact Author)

Università degli studi di Modena e Reggio Emilia (UNIMORE) - School of Doctorate E4E (Engineering for Economics-Economics for Engineering) ( email )

Italy

Andrea Marchioni

Università degli studi della Tuscia - Department of Economics, Engineering, Society and Business, University of Tuscia, Via del Paradiso 47, 01100 Viterbo, Italy ( email )

Rettorato, Via S.M.in Gradi n.4
Viterbo, 01100
Italy

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
103
Abstract Views
818
Rank
469,563
PlumX Metrics