Consequences of the Absence of Monotonicity of the NPV Function to the Assessment of Effectiveness of Investment Projects

Paweł Merło
2016 Engineering Economics  
Discount methods do not pose difficulties in calculating and interpreting their outcome as long as the NPV function is monotonic. However, the loss of monotonicity can create obstacles to efficient applications of the mentioned methods. Thus, the thesis developed herein is that the major cause of problems encountered while calculating and interpreting profitability indices based on the discount technique is the course of the NPV function. The objective has been to identify and evaluate
more » ... d evaluate situations which may lead to the loss of monotonicity of the NPV, which in turn creates problems when making an assessment of the profitability of an investment and consequently can lead to an erroneous evaluation of the profitability of a planned investment project, whose assessment has been supported by discount methods. To this aim, the course of the function's variability has been scrutinized, and in particular zero points, the function's extreme values and intervals of monotonicity have been determined. The study has verified the research thesis and demonstrated that an assessment becomes more difficult when the NPV function's monotonicity is lost, which may lead to the appearance of more than one internal return rate. The current state of knowledge on this matter suggests that various modifications of such methods should be used in order to avoid any ambiguity of measures in case the NPV function is non-monotonic. However, it is not infrequent that instead of eliminating disadvantages of discount methods the said modifications lead to a mistaken interpretation of the achieved results. Then, a more radical solution is to use an NPV measure as one unburdened with errors originating from unconventional cash flows and to abandon measures like the IRR. However, this solution may also be incorrect because -despite obtaining a single NPV measure -its interpretation cannot be adequate due to the function's intervals in which the NPV increases together with an increasing discount rate, which can lead to an absurd conclusion that an investment project would become more profitable if the cost of capital was higher. Consequently, the methodology for evaluation of the profitability of investment projects employed until today cannot be considered as a correct approach as it may lead to making an unoptimal decision.
doi:10.5755/j01.ee.27.1.6334 fatcat:tmivc5dm35dbxfywzcbydcqtfm