RANKING MUTUALLY EXCLUSIVE PROJECTS: THE ROLE OF DURATION

This paper develops a new measure of cash-flow timing called “return duration.” Numerically quite close to Macaulay duration, return duration is a straightforward function of a project's net present value (NPV) and internal rate of return (IRR). When comparing mutually exclusive projects, differences in return duration can explain ranking conflicts between NPV and IRR. The paper also clarifies the conditions under which a manager should consider duration or generalized NPV before making investment decisions when faced with such ranking conflicts.     

投资项目财务评价内部收益率的比较研究

投资项目财务评价是可行性研究报告的核心内容之一,而内部收益率是判断项目财务可行性和预期盈利能力的主要指标。从内部收益率的经济含义入手,分析了项目投资内部收益率、项目资本金内部收益率和投资各方内部收益率3类内部收益率的适用条件和数量关系,认为项目投资内部收益率是项目融资前决策的首选指标,且只需计算所得税前指标;资本金内部收益率是项目融资决策分析的主要指标,当项目投资内部收益率大于银行利率时,资本金内部收益率大于项目投资内部收益率;当各股东（投资方）同股非同权或存在股权之外的收益分配时,需要计算投资各方内部收益率。     

A review of: “APPLIED ECONOMIC ANALYSIS FOR TECHNOLOGISTS,ENGINEERS, AND MANAGERS ” BY MICHAEL S. BOWMAN Prentice-Hall,Inc., Upper Saddle River,New Jersey, 1999, xii + 561 pp., ISBN: 0-13-375932-6, List: $76.75.

In their recent paper Tang and Tang (2003 Tang, S. L. and Tang, H. J. 2003. The variable financial indicator IRR and the constant economic indicator NPV.. The Engineering Economist, Vol. 48(No. 1): pp. 69–78. [Taylor &; Francis Online] , [Google Scholar], pp. 69–78) revive a longstanding controversy—net present value (NPV) versus internal rate of return (IRR)—by characterizing the NPV as an economic indicator and the IRR as a financial one. The paper implies that this distinction justifies ranking financial alternatives by ranking their IRRs. In the current article, it is argued that the direct IRR ranking does not necessarily provide the same evaluation environment—and therefore a fair comparison—for each alternative involved, and that the incremental ranking approach is needed to remedy this shortcoming. The article also points out that Tang and Tang's numerical examples of simple projects with one sign change in their cash flow patterns do not address the problem of multiple IRRs, which consequently renders Tang and Tang's ranking approach dysfunctional. It is demonstrated that the concept of a true rate of return, substituting for the non-performing IRR and applied in conjunction with the incremental approach, provides an adequate tool for ranking mutually exclusive projects or a project's technical or financial alternatives.     

A Review of: “An Introduction to Mathematical Finance: Options and Other Topics By Sheldon M. Ross” Cambridge University Press,New York,New York, 1999, xv + 184 pp. ISBN ( 521-77043-2. List: $37.95. (hardback)

Surveys of businesses' capital budgeting practices reveal that the IRR is much preferred over the NPV as an investment decision making tool even though business scholars prescribe the NPV as theoretically optimal. Here practitioners' preference for the IRR is explained through ergonomics: the IRR is treated as a display method. As such it is more compatible with decision makers' expectations and therefore, is more cognitively efficient. Because the IRR is expressed as an interest rate, it more closely resembles an analog display, in which the IRR is simply compared to the required return. In contrast, the NPV is stated in dollars, resembling more a very precise digital display. Academicians should reorient their efforts from promoting the NPV to teaching methods to ameliorate the pitfalls of the IRR.     

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 project's 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.     

A NEW APPROACH TO DEPRECIATION MEASUREMENT FOR PUBLIC UTILITIES: COMMENT

This paper examines the use of a simple heuristic for evaluating projects. We posit that ranking projects by IRR and rejecting marginal projects can be superior to a NPV rule if 1) project managers have incentives to overstate cash flow forecasts that occur late in a project's life, 2) project rankings determine project acceptance because not all positive NPV project's are accepted, and 3) a project's IRR is greater than the WACC. In these instances, the IRR heuristic undervalues distant cash flows and thus, reduces project managers' incentives to positively bias forecasts.     

A Review of: ADVANCED TECHNIQUES FOR STRATEGIC PLANNING by Ernest C. Miller

The Net Present Value (NPV) rule of financial theory gives management a decisive criterion for choosing between abandonment versus continuation of capital projects. There is extensive evidence, however, that management chooses to delay the abandonment of unprofitable projects. This paper attempts to explain management's reluctance to abide by the NPV criterion. The concept of a Reputation Adjusted Net Present Value is introduced in an environment where management knows more about the true value of a project than do stakeholders. The model indicates that, in such an environment, the continuation of a negative NPV project may maximize firm value.     

THE IMPACT OF POLITICAL RISK ON THE FOREIGN DIRECT INVESTMENT DECISION: A CAPITAL BUDGETING ANALYSIS

Using a capital budgeting framework, we examine the impact of political risk on the foreign direct investment decision. Political risk may alter operating cash flows via discriminatory regulations as well as the investment via expropriation. We model the impact of political operating costs and expropriation costs on the NPV of a project under the assumption that the parameters that affect the NPV are constant over the life of the project. Next, we provide an illustration for the case in which the relevant parameters are variable over the life of the project. The paper concludes with an example of political risk in the 1990s, the case of Black Sea Energy Ltd.'s investment in Russia.     

A LETTER TO THE AUTHOR

Effective communication of capital investment proposals can be critically important to an engineer's professional development. Engineers frequently have difficulty developing this effective communication, however, primarily because they lack a clear understanding of the corporate decision-makers' commercial perspective and related informational needs. The decision-makers' perspective and the capital budgeting process are explored and several communication strategies are suggested to assist the engineer in more effectively presenting his capital investment proposals. The value of communication technique and the importance of recognizing and dealing effectively with certain psycho-social factors in inter-personal communication are briefly described.     

A note on the sensitivity analysis of the internal rate of return

In this note we discuss the sensitivity analysis of the internal rates of return (IRR). We show that the use of partial derivatives can be misleading in the identification of key drivers of an investment project's performance. To remedy this shortcoming, we propose the use of an alternative sensitivity measure called the Differential Importance Measure. The analysis shows that, even if the theoretical conditions for using the Net Present Value or the IRR as valuation criteria apply, the sensitivity analysis results for the two indicators may differ.     

The right speed and its value

Slow investments cause substantial revenue losses, yet acceleration increases costs. This tradeoff implies that an optimal investment speed usually exists; it is faster the higher a firm's intrinsic speed capability. We hypothesize that it is a firm's intrinsic speed capability, rather than its speed relative to industry competitors per se, that boosts firm value. Using data on oil and gas facilities (1996–2005), we find that intrinsic speed capabilities augment firm value in a varied way: their value is larger with better corporate governance, lower cost of capital, and higher ability to draw value from R&D investment. Our work elevates the discussion of speed from a project‐level consideration to a firm‐level competitive advantage issue and raises the need to further explore its strategic value. Copyright © 2013 John Wiley & Sons, Ltd.     

Measuring and Utilizing Corporate Risk Tolerance to Improve Investment Decision Making

Strategic investment decisions are generally characterized by financial risk as well as an irrevocable commitment of significant amounts of capital. The firm's willingness to undertake financial risks plays an important role in the investment decision making process. A comprehensive economic decision analysis to evaluate strategic investment decisions requires a measure of the firm's tolerance for financial risk. This article describes a decision analysis–based technique for assessing managerial risk tolerance as well as managers' ability to be consistent in terms of their financial risk taking. These assessments are then utilized to assist the firm in establishing a corporate risk policy that can guide strategic decisions under uncertainty. The study firm is a business unit within a U.S.-based major oil company with an annual capital budget of approximately $400 million. Our findings suggest that managers are generally risk averse but struggle in terms of being consistent in their financial risk-taking decisions. This work enabled the firm to implement a financial risk tolerance that could be utilized in the economic decision analysis of investment decisions.     

RECONSIDERING THE SUNK-COST CONCEPT

This paper presents a decision procedure to aid in making capital rationing investment and borrowing decisions. Weingartner's Basic Horizon Model and Oakford and huesen's Maximum Prospective Value criterion are both extended to explicitly include long-term borrowing decisions. Information derived from interviews with financial executives on the subject of business attitudes toward borrowing is used to develop the conceptual logic of the decision procedure, which is presented in terms of a mathematical programming formulation.     

CEO incentives,innovation, and performance in technology‐intensive firms: a reconciliation of outcome and behavior‐based incentive schemes

Building on the agency view of corporate governance, we propose that technology‐intensive firms use both outcome and behavior‐based performance criteria for rewarding CEOs. Using a sample of 206 firms from 12 U.S. manufacturing industries, we find that as technological intensity increases CEO bonuses are more closely linked to financial results and that total CEO incentives are associated with two indicators of desirable innovation behaviors: invention resonance and science harvesting. Invention resonance refers to the impact a firm's inventions have on other firms' inventions, while science harvesting reflects a firm's commitment to scientific research. As technological intensity increases, aligning bonus with financial results, total incentives with invention resonance, and total incentives with science harvesting predict firm market performance. Copyright © 2006 John Wiley & Sons, Ltd.     

Double vision: Insights about the origin and interpretation of multiple IRRs

The ability of a project's internal rate of return (IRR) to quantify its economic return has been questioned by many scholars over the past 60 years, most recently by Magni (2010 Magni, C.A. (2010) Average internal rate of return and investment decisions: a new perspective. The Engineering Economist, 55(2), 150–180. [Google Scholar], 2013 Magni, C.A. (2013) The internal rate of return approach and the AIRR paradigm: a refutation and a corroboration. The Engineering Economist, 58(2), 73–111. [Google Scholar]). Although IRR is a plausible—albeit imperfect—measure of a project's economic return when the cash flow stream is conventional, IRR can be an untenable measure of an unconventional project's economic return. The goal of this article is to identify a simple, intuitive explanation of IRR, one that can be applied to any cash flow pattern. To do this, the article shows how a project's IRR systematically changes when it first crosses from the conventional into the unconventional realm (i.e., a small cash outflow is appended to a conventional cash flow stream) and then as it becomes progressively more unconventional. This process reveals that the most robust economic interpretation of IRR—for both conventional and unconventional projects—is that a project's IRRs are external benchmarks that divide the set of all plausible discount rates into positive and negative net present value (NPV) ranges, rather than internally generated returns. Because it can be difficult to estimate a project's cost of capital with precision, this information can help guide the sensitivity analysis of a project.     

Whether and when do alliance terminations pay off?

Engaging in multiple strategic alliances, a firm forms an alliance portfolio. While a larger alliance portfolio signals investors a firm's ability to exploit new opportunities and improve financial performance, having multiple alliances may also undermine financial performance due to a firm's limited ability to effectively manage these alliances. Announcing an alliance termination, a firm signals an intention to increase the effectiveness of a larger alliance portfolio. This article examines the extent to which alliance termination announcements create value for firms with multiple alliances. Building on the resource-based view of the firm and organizational learning literature, the paper hypothesizes a U-shaped relationship between alliance portfolio size and a firm's cumulative abnormal stock return following an alliance termination announcement. This effect is moderated by the amount of a firm's alternative resources and partner-specific experience that affect its ability to effectively manage multiple alliances. The results show that alliance termination announcements create firm value when an alliance portfolio is large.     

Stochastic Oil Price Models: Comparison and Impact

A good investment decision-making process is one that is able to assess risk and uncertainty and manage them in a balanced manner. Literature on current oil and gas industry practice indicates that the modeling of uncertainty is largely restricted to reserves while production, cost, and oil price data are all single point deterministic values indicating certainty. The objective of this article is to explore the impact of three stochastic oil price models: geometric Brownian motion (GBM), mean reversion (MR) and mean reversion with jumps, on the uncertainty output of a project's net present value (NPV). Furthermore, it investigates the impact of varying the input parameters of the three stochastic oil price models. This article concludes that range in the project NPV values using the MR with jumps model is far greater than the MR and GBM models. In addition, if the decision is based on the mean value, then the GBM model is a good approximation if the current oil price is close to the long-term price. However, if the decision is based on the standard deviation, GBM does not provide a good approximation. Finally, uncertainty in the volatility of oil price has a significant impact only in the GBM model, but not on the MR or the MR with jumps models.     

PRINCIPLES OF- ENGINEERING ECONOMIC ANALYSIS by John A. White,Marvin H. Agee and Kenneth E. Case,John Wiley & Sons,Inc., New York, 1984, 2nd Ed., xii + 546 pp., List $32.95.

In his three recent papers [3], [4], and [5], R.G. Beaves develops an Overall Rate of Return (ORR) project evaluation criterion based on the concept of the so-called transition point (TP) which he has defined in two different versions.¹ In the present contribution, it is shown that some projects may produce undefined ORRs for either TP version, and that other ORR-like criteria [7] may also generate undefined results for projects for which the Net Present Value (NPV) criterion is defined. To eliminate the cases of the ORR undefinability, a generalization of the ORR criterion is proposed that makes this criterion fully NPV compatible and applicable to both investment and financing projects. This criterion embraces all the existing ORR approaches that are based on the notions of the initial and terminal wealths, including both of Beaves' approaches.     

EXPLOITING UNCERTAINTY—INVESTMENT OPPORTUNITIES AS REAL OPTIONS: A NEW WAY OF THINKING IN ENGINEERING ECONOMICS

A new trend in corporate planning is to exploit uncertainty by taking investment opportunities as real options. This options approach is to complement the conventional net present value (NPV) criterion in evaluating risky investments. In this paper, we take a broad look at the real options approach to various engineering economic decision problems, laying out how it provides an immediate and important perspective on value creation in an uncertain world. Unlike financial options, real options analysisdeals with investments in real assets, which is one of the primary interest areas in engineering economics. For that reason, we believe that any advancement in the real options decision framework will benefit the field of engineering economics.     

油气勘探开发投资绩效评价的指标选择

提出了一个如何评价油气勘探开发投资绩效的问题，并根据油气勘探、开发投资的特性及投资绩效评价指标的选择原则，并辅以单位勘探成本、单位开发成本两个指标进行比较和分析，阐明了采用单位勘探开发成本作为主要评价指标以替代目前油田企业沿用多年的旧指标的依据。