What is it about?
Companies use several methods to evaluate long-term investment projects. Although net present value (NPV) is generally considered a sound approach, financial decision makers often prefer percentage-return measures such as the internal rate of return (IRR) and modified internal rate of return (MIRR). This study proposes a new measure called purchasing power return (PPR). PPR converts project cash flows into constant purchasing-power terms and calculates an expected real return that can be compared with an inflation-adjusted required return. PPR is designed to produce investment decisions that are mathematically consistent with NPV.
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Why is it important?
Percentage-return measures are intuitive and widely used in evaluating long-term investments, but traditional measures such as IRR and MIRR have important limitations that can create difficulties in interpreting or comparing investment projects. PPR provides an alternative percentage-return measure that addresses these limitations while maintaining consistency with NPV. It also identifies positive-NPV projects that are expected to reduce a company's purchasing power, allowing financial decision makers to subject such projects to additional review. The approach therefore combines the intuitive appeal of a percentage return with the theoretical strengths of NPV.
Perspectives
The motivation for this study came from recognizing the limitations of commonly used percentage-return measures for evaluating long-term investment projects. Although IRR and MIRR provide returns that are easy to communicate, they have shortcomings that can complicate capital investment decisions. We wanted to develop an alternative percentage-return measure that addresses these problems while remaining mathematically consistent with NPV. The resulting purchasing power return approach evaluates projects in terms of purchasing power and also identifies projects that may reduce a company's purchasing power despite having a positive NPV. I hope this study provides financial decision makers with a useful alternative for evaluating long-term investment projects.
Dr. Hongbok Lee
Western Illinois University
Read the Original
This page is a summary of: Purchasing power return, a new paradigm of capital investment appraisal, Managerial Finance, February 2018, Emerald,
DOI: 10.1108/mf-07-2017-0265.
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