Carlo Alberto Magni

Average Internal Rate of Return and Investment Decisions: A New Perspective

The internal rate of return (IRR) is often used by managers and practitioners for investment decisions. Unfortunately, it has serious flaws: (1) multiple real-valued IRRs may arise; (2) complex-valued IRRs may arise; (3) the IRR is, in general, incompatible with the net present value (NPV) in accept/reject decisions; (4) the IRR ranking is, in general, different from the NPV ranking; (5) the IRR criterion is not applicable with variable costs of capital. The efforts of economists and management scientists in providing a reliable project rate of return have generated over the decades an immense bulk of contributions aiming to solve these shortcomings. This article offers a complete solution to this long-standing unresolved issue by changing the usual perspective: the IRR equation is dismissed and the evaluator is allowed to describe the project as an investment or a borrowing at his discretion. This permits showing that any arithmetic mean of the one-period return rates implicit in a project reliably informs about a projects profitability and correctly ranks competing projects. With such a measure, which we call average internal rate of return, complex-valued numbers disappear and all the above-mentioned problems are wiped out. The economic meaning is compelling: it is the project return rate implicitly determined by the market. The traditional IRR notion may be found as a particular case.

The Internal-Rate-of-Return Approach and the AIRR Paradigm: A Refutation and a Corroboration

This article shows that the internal rate of return (IRR) approach is unreliable and that the recently introduced average internal rate of return (AIRR) model constitutes the basis for an alternative theoretical paradigm of rate of return. To this end, we divide the paper into two parts: a pars destruens and a pars construens. In the “destructive” part, we present a compendium of 18 flaws associated with the IRR approach. In the “constructive” part, we construct the alternative approach from four (independent) economic intuitions and put the paradigm to the test by showing that it does not suffer from any of the flaws previously investigated. We also show how the IRR, as a rate of return, is absorbed into the new approach.

Investment decisions in the theory of finance: Some antinomies and inconsistencies

Abstract The net-present-value rule is a pillar of modern finance theory. As known, it is a capital budgeting rule. Finance theory prescribes the investor to compare the opportunity in hand with an asset of equivalent risk, i.e. to discount cash flows with a risk-adjusted rate of return. This paper aims at showing that inconsistencies and antinomies arise when applying the above-mentioned rule. Further, it turns out that it is actually impossible to compare alternatives equivalent in risk and any decision maker cannot prevent herself to violate the above tenet.

Correct or Incorrect Application of CAPM? Correct or Incorrect Decisions With CAPM?

This paper focuses on inconsistencies arising from the use of NPV and CAPM for capital budgeting. It shows that (i) CAPM capital budgeting decision-making based on disequilibrium NPV is deductively inferred by the Capital Asset Pricing Model, (ii) the use of the disequilibrium NPV is widespread in finance both as a decision rule and as a valuation tool, (iii) the disequilibrium NPV does not guarantee additivity nor consistency with arbitrage pricing, so that it is unreliable for valuation, (iv) Magni’s (2002, 2007a, forthcoming) criticism of the NPV criterion refers to the disequilibrium NPV, and De Reyck’s (2005) project valuation method, on the basis of which Magni’s criticism to NPV is objected, leaves decision makers open to arbitrage losses and incorrect decisions.

Investment Decisions, Net Present Value and Bounded Rationality

The Net Present Value maximizing model has a respectable ancestry and is considered by most scholars to be a theoretically sound decision model. In real-life applications, decision makers use the NPV rule, but apply a subjectively determined hurdle rate, as opposed to the ‘correct’ opportunity cost of capital. According to a heuristics-and-biases-program approach, this implies that the hurdle-rate rule is a biased heuristic. This work shows that the hurdle-rate rule may be interpreted as a fruitful strategy of bounded rationality, where several domain-specific and project-specific elements are integrated and condensed into an aspiration level. The paper also addresses the issue of a productive cooperation between bounded and unbounded rationality.

The Use of Fuzzy Logic and Expert Systems for Rating and Pricing Firms: A New Perspective on Valuation

Purpose – The purpose of the paper is to focus on the rating, ranking and valuing of firms.Design/methodology/approach – Fuzzy logic and expert systems are used in order to provide a score for the firm(s) under consideration, representing the firm value‐creating power.Findings – The fuzzy expert system introduced is capable of dealing with both quantitative and qualitative variables and integrates financial, managerial and strategic variables. A sensitivity analysis corroborates the model.Research limitations/implications – The system is apt to rate and rank firms within a sector. Some regression analysis can lead to a determined price for the target firm.Practical implications – The expert system may be used by rating agencies for ranking firms, and by financial analysts and potential buyers to furnish a price for acquisition.Originality/value – The use of a fuzzy expert system for ranking firms within a sector and pricing firms is a first attempt at an alternative way of measuring performance and value.

Decomposition of Net Final Values: Systemic Value Added and Residual Income

This paper proposes a model aiming at decomposing the Net Final Value of a project under certainty. It makes use of a systemic outlook: the investors net worth is regarded as a dynamic system whose structure changes over time. On this basis, a profitability index is presented, here named Systemic Value Added (SVA), which lends itself to a periodic decomposition: the periodic shares formally translate the economic concept of residual income (or excess profit). While as an overall index the Systemic Value Added coincides with the Net Final Value (NFV) of an investment, the systemic partition of a SVA is shown to differ from the NFV decomposition model proposed by Peccati (1987, 1991, 1992), which in turn bears a strong resemblance to Stewarts (1991) EVA model. The SVA model and the NFV-based model bear interesting relations: by introducing the concept of a shadow project the SVA model can be re-shaped so that the decomposition of the SVA can be accomplished by applying Peccatis argument to the shadow project , or, which is the same, by computing the shadow project s Economic Value Added. The paper then generalizes the approach allowing for a portfolio of projects, multiple debts and multiple synchronic opportunity costs of capital, for which a tetra-dimensional decomposition is easily obtained. Copyright Blackwell Publishing Ltd and the Board of Trustees of the Bulletin of Economic Research 2003.

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

The recent notion of average internal rate of return (AIRR; Magni 2010a, The Engineering Economist, 55(2), 150–180) completely solves the long-standing problem of the internal rate of return (IRR). Though the AIRR is a return measure, this article 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, because 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, economically significant hurdle rate: 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 net present value (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 IRRs nature (rate of return versus rate of cost) does not depend on the market rate and is unambiguously determined by the capital invested.

Project Valuation and Investment Decisions: CAPM Versus Arbitrage

This study shows that (a) project valuation via CAPM contradicts valuation via arbitrage pricing, (b) CAPM-minded decision makers may fail to profit from arbitrage opportunities, (c) Standard CAPM-based valuation violates value additivity. As a consequence, the use of CAPM for project valuation and decision making should be reconsidered.

A Fuzzy Expert System for Solving Real-Option Decision Processes

This paper presents a new approach to real options. The current options-based models have provided new insights into capital-budgeting decisions. Unfortunately they are not widely used by corporate managers and practitioners as they are formally complex, rather difficult to understand and rest on strong implicit assumptions that considerably limit their scope of application. We propose a possible alternative by using a fuzzy expert system, on the basis of Mastroleo, Facchinetti and Magni (2001). We draw up a decision tree with multiple uncertain variables affecting the value of an investment opportunity, consisting of a defer option, a growth option, an abandonment option. Some simulations are conducted to test the economic soundness of the model as well as its consistency with the current models in the literature. A rather refined study can be accomplished by showing how inputs and outputs of the model interrelate one another.