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

The Engineering Economist, Vol. 56, No. 2, pp. 140–169, 2011

33 Pages Posted: 28 Jul 2010 Last revised: 23 Jul 2011

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)

Date Written: July 28, 2010

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

Suggested Citation

Magni, Carlo Alberto, Aggregate Return on Investment and Investment Decisions: A Cash-Flow Perspective (July 28, 2010). The Engineering Economist, Vol. 56, No. 2, pp. 140–169, 2011, Available at SSRN: https://ssrn.com/abstract=1649604

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

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