Calculating Return on Investment the Perils and the Pitfalls; Commonly Used Financial Tools Such as Net Present Value and Internal Rate of Return Are Resulting in Skewed Investment Decisions, Argues Andrew Vocino. Fortunately There Is an Alternative. (Investment Returns)
Vocino, Andrew, Journal of Banking and Financial Services
Until an investment returns a capital gain, it must produce a return higher than the cost of capital in order to be worthwhile. While this hardly comes as a surprise to a banker--indeed no investor likes to lose money--traditional evaluation methods may give wrong or distorted information leading to bad investment decisions. This is especially the case with internal rate of return (IRR) measurements, which can portray an investment as having been recovered when in fact this is not the case.
Valuing a company's assets and the income streams derived from the company is one of the most important issues in current accounting research. The measurement of profitability is closely linked to this issue. A theoretically sound and pragmatic profitability measurement is also crucially important to the welfare of the economy overall. The allocation of resources in an economy is directly affected by the validity and reliability of these performance measures.
There are several systems through which a company's management can evaluate business opportunities. In effect a company can be seen as a portfolio of investment options, such as the launch of a new product or the acquisition of a competitor. All are competing for scarce capital. The right investment should not only result in a longer term increase in the value of the company, but produce a return at least slightly better than the capital cost.
The investment evaluation process usually consists of two phases which at first are distinct and then later converge: business analysis and technical processing. The first phase defines the opportunity and the strategic context of the proposed investment; the second phase instead defines the analytical elements needed to evaluate the opportunity.
In many situations management tends to put pressure on one of the two sides without having a fair balance. For instance, management might be driven by the emotional desire to crush a competitor, even if this diminishes the company's value. Conversely, the decision makers are hyper-analytical, relying on computer generated data without considering their own knowledge and gut feel of the market. A correct system should provide a balance between the two phases.
Typical problems with evaluation methods
The net present value (NPV) rule is the most common economic evaluator for selecting projects. Cash flows at different times are combined to produce the NPV or the net present worth (NPW) by summarising their present values (PVs).
If the NPV is more than zero, the project is worthwhile. If not, it is ditched. This is known as the NPV rule and it has a number of positive features: it recognises the time value of money and it depends solely on forecasted actual cash flows from the project. As all of the values are measured in current dollars, the NPVs can be added up. This allows one to avoid accepting a bad project just because it is tacked onto a good one, as this would lower the overall NPV.
However, there are several drawbacks to using NPV as well. Just because a project has a positive NPV, it does not necessarily result in an increase in the company's value (and therefore shareholder value). The NPV is also not easily comparable with other investment alternatives such as treasury bills, which also compete for capital. This is because NPV is expressed as an absolute value and not as a percentage.
A company uses the payback period rule by setting a cut-off date by which the initial outlay on the project must be recovered. Three years is a common example.
There are a few disadvantages to this rule, essentially all having to do with timing of the cash flows. Firstly, the concept of a cut-off date is quite arbitrary; after all, what if a project is a long-term one and does not really begin to generate serious cash flows for some time? This is certainly the case with research and development projects. …