Investment Decisions and Sensitivity Analysis: NPV-Consistency of Rates of Return

Abstract

Investment decisions may be evaluated via several different metrics/criteria, which are functions of a vector of value drivers. The economic significance and the reliability of a metric depend on its compatibility with the Net Present Value (NPV). Traditionally, a metric is said to be NPV-consistent if it is coherent with NPV in signalling value creation. This paper makes use of Sensitivity Analysis (SA) for measuring coherence between rates of return and NPV. In particular, it introduces a new, stronger definition of NPV-consistency that takes into account the influence of value drivers on the metric output. A metric is strongly NPV-consistent if it signals value creation and the ranking of the value drivers in terms of impact on the output is the same as that provided by the NPV. The degree of (in)coherence is calculated with Spearman's (1904) correlation coefficient and Iman and Conover's (1987) top-down coefficient. We focus on the class of AIRRs (Magni 2010, 2013) and show that the average Return On Investment (ROI) enjoys strong NPV-consistency under several (possibly all) methods of Sensitivity Analysis.

Keywords: Finance, operational research, engineering economics, investment decisions, sensitivity analysis, NPV, Return On Investment, consistency, average, AIRR

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