Sensitivity Analysis and Investment Decisions: NPV-Consistency of Straight-Line Rate of Return

Abstract

The economic reliability of a performance metric depends on its consistency with the Net Present Value (NPV). We use the new notion of strong NPV-consistency for comparing the Straight-Line rate of return (belonging to the class of AIRR metrics) and the traditional Internal Rate of Return (IRR). We show that the IRR is unreliable and its degree of NPV-inconsistency is not negligible via Spearman's (1904) correlation coefficient and Iman and Conover's (1987) top-down coefficient. In contrast, Straight-Line rate of return is strongly NPV-consistent, always exists, is unique, and has an unambiguous financial nature.

Keywords: Sensitivity Analysis, Investment Decisions, NPV, Consistency, Straight-Line Rate of Return, IRR

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