Authors: Mikhail Sokolov (European University, Centre for Econometrics and Business Analytics (CEBA).
Abstract: We introduce a class of investment project’s profitability metrics that includes the net present value criterion (which labels a project as weakly profitable if its NPV is nonnegative), the internal rate of return (IRR), the profitability index (PI), the payback period (PP) and its discounted counterpart (DPP) as special cases. An axiomatic characterization of this class, as well as of the mentioned conventional metrics within the class, is presented. This approach is useful at least in three respects. First, it suggests a unified interpretation for profitability metrics as measures of financial stability of a project with respect to a collection of scenarios of economic environment. Second, it shows that, with the exception of the NPV criterion, a profitability metric is necessarily incomplete (i.e., there are incomparable projects). In particular, this implies that any extension of the IRR to the space of all projects does not meet a set of reasonable conditions. A similar conclusion is valid for the other mentioned conventional metrics. For each of these metrics, we provide a complete characterization of pairs of compatible projects and describe the largest subset of projects to which the metric can be unambiguously extended. Third, it determines the conditions under which the use of one metric is superior to the others.
Link to work
Abstract: We introduce a class of investment project’s profitability metrics that includes the net present value criterion (which labels a project as weakly profitable if its NPV is nonnegative), the internal rate of return (IRR), the profitability index (PI), the payback period (PP) and its discounted counterpart (DPP) as special cases. An axiomatic characterization of this class, as well as of the mentioned conventional metrics within the class, is presented. This approach is useful at least in three respects. First, it suggests a unified interpretation for profitability metrics as measures of financial stability of a project with respect to a collection of scenarios of economic environment. Second, it shows that, with the exception of the NPV criterion, a profitability metric is necessarily incomplete (i.e., there are incomparable projects). In particular, this implies that any extension of the IRR to the space of all projects does not meet a set of reasonable conditions. A similar conclusion is valid for the other mentioned conventional metrics. For each of these metrics, we provide a complete characterization of pairs of compatible projects and describe the largest subset of projects to which the metric can be unambiguously extended. Third, it determines the conditions under which the use of one metric is superior to the others.
Link to work