Aggregate Return on Investment and Investment Decisions: A Cash-Flow Perspective

Abstract

The recent notion of Average Internal Rate of Return (AIRR) [Magni 2010, The Engineering Economist, 55(2), 150-180] completely solves the long-standing problem of the internal rate of return (IRR). While the AIRR is a return measure, this paper presents a cash-flow measure, namely the ratio of net cash flow (i.e., cash inflows minus cash outflows) to capital invested, which we call Aggregate Return On Investment (AROI). It is a purely internal measure because, unlike the AIRR, it does not depend on the market rate, and is a return measure, for it is a mean of one-period return rates, weighed by the outstanding capitals. The AROI is reliable in both accept/reject decisions and project ranking, in association with an appropriate hurdle rate, economically significant: the comprehensive cost of capital (CCOC), which takes into account not only the interest foregone on the capital actually employed, but also the interest foregone on the capital that is given up by the investor. This perspective enables one to decompose the project NPV into an excess-rate share and an excess-capital share. The traditional IRR is just a particular case of both AIRR and AROI, but the latter approach has the advantage that the IRR’s nature (rate of return versus rate of cost) does not depend on the market rate and is unambiguously determined by the capital invested.

Note: Previously titled: Purely Internal Rate of Return and Investment Decisions: A Cash-Flow Perspective

Keywords: Decision analysis, investment criteria, rate of return, cash flow, cost of capital, net present value

JEL Classification: G11, G12, G31