PERPETUITY RATE OF RETURN ANALYSIS

This paper introduces a new method of capital project analysis called the perpetuity rate of return (PRR). As implied by its name, the PRR is found by transforming a project's cash flow stream into a perpetuity and then relating this value to the required investment outlay. The PRR method is essentially a compromise between the NPV and IRR techniques. Like the NPV, the PRR correctly values a project's cashflows by using the market-determined cost of capital as the discount rate; like the IRR, the PRR is a rate of return that is appropriately compared to the cost of capital to determine a project's acceptability. The new yield-based method fares well in comparison with the IRR on a conceptual level and appears to have practical potential.     

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.     

The Maximum Prospective Value Criterion

In this paper the authors analyze the logic of the capital budgeting decision in two different settings. First it is assumed that the decision-maker has complete information about both his current and future investment opportunities in which case the decision problem reduces basically to a computing problem. Second it is assumed that the decision maker has complete information about his current investment opportunities and a knowledge of his expectations about future investment opportunities.

The authors analyze the logic underlying the selection of the capital growth (discount) rate that should be used in determining whether a marginal increment of investment should be accepted or rejected. If the marginal increment were rejected, the unused cash would typically be invested temporarily in a highly liquid investment at a relatively low interest rate with the prospect that a better than marginal investment would absorb the funds at the next decision time.

The analysis led to the formulation of a capital-budgeting decision criterion, called the Maximum Prospective Value Criterion, which is presented in this article. As its name implies, the criterion is designed to select the set of investments that has the maximum prospective value, given the decision-maker's expectations about his future investment opportunities. This criterion relates the capital-budgeting decision to the opportunity-cost and marginal-analysis concepts of classical economics. The present-worth criterion of engineering economy is shown to be a special case of the Maximum Prospective Value Criterion, and the minimum at tractive rate of return of engineering economy when properly selected appears to be closely related to the capital growth rate on the marginal increment of investment.     

A Review of: “ECONOMIC ANALYSIS AND INVESTMENT DECISIONS” by Chi U. Ikoku,John Wiley and Sons,New York, 1985, xx + 277 pp., ISBN 0471-81455-5, List $34.95.

(Payback Plus 2.0 is an updated version of PAYBACK which had earlier been released by the Society of Manufacturing Engineers (SME). This new software package is published and distributed by MiCAPP Inc., 16956 230th Avenue, Big Rapids, Michigan 49307. It is available for the IBM-PC or compatible equipment; the advertised list price is £99 + £4 shipping and handling.)     

Economic design of an chart for short-run production

The aim of this paper is to present an economical design of an X chart for a short-run production. The process mean starts equal to μ₀ (in-control, State I) and in a random time it shifts to μ₁>μ₀ (out-of-control, State II). The monitoring procedure consists of inspecting a single item at every m produced ones. If the measurement of the quality characteristic does not meet the control limits, the process is stopped, adjusted, and additional (r-1) items are inspected retrospectively. The probabilistic model was developed considering only shifts in the process mean. A direct search technique is applied to find the optimum parameters which minimizes the expected cost function. Numerical examples illustrate the proposed procedure.     

PREPAYMENT OF INCOME TAX: A “SPREADSHEET” ANALYSIS

In their recent paper ( D. Asquith &; J.E. Bethel, “Using Heuristics to Evaluate Projects: The Case of Ranking Projects by IRR,” The Engineering Economist, Vol. 40, No. 3 (Spring 1995, pp. 287-294) ), the authors propose a project ranking procedure that is supposed to mitigate the impact of cash flow overvaluation by project managers. In the current contribution, it is indicated that this procedure is based upon a project ranking approach that employs the IRR criterion in a theoretically inadequate way. The correct, incremental approach to the IRR-based project ranking is reiterated, and it is shown that if this approach is applied, then its very design reduces the impact of CF-biases on project ranking. It is also demonstrated that even if competing projects are of equal scale, they must still be ranked by incremental comparison. Finally, it is pointed out that the incremental project ranking is the proper approach regardless of which NPV-compatible profitability measure is applied.     

Who Invented the Lerner Index? Luigi Amoroso, the Dominant Firm Model, and the Measurement of Market Power

The invention of the price/cost margin (P-MC)/P as an index of market power is usually credited to Lerner (Rev Econ Stud 1(3):157?C175, 1934). Landes and Posner (Harv Law Rev 94(5):937?C996, 1981) is similarly often considered the main reference for the generalized version of the index in the case of a dominant firm that shares the market with price-taking rivals. From the viewpoint of the history of industrial economics both claims are incorrect. It was not Lerner who invented the price/cost margin index and the generalized version was fully derived before WWII. In both cases, priority should be given to Luigi Amoroso, the leading Italian mathematical economist in the interwar decades. In the latter case the names of Heinrich von Stackelberg and George Stigler also deserve credit.     

Cost-benefit analysis of agricultural research: hybrid maize reconsidered

This paper reviews the use of benefit-cost ratio, and the internal or external rate of return for ex post and ex ante assessment of agricultural research projects. The classic data on hybrid maize are used to illustrate unsatisfactory features of these criteria. In the absence of practicable optimization procedures, it is suggested that the net benefits of projects might be quantified, then judgment exercised on patterns of resource usage as well as on social consequences. Present value of net benefits is sensitive to discount rate and to the base year taken for discounting, but an ‘equivalent annual flow’ is a useful alternative form of expression. It is finally pointed out that the rejection of the high rates of return on agricultural research published in many retrospective studies does not weaken the case for investment in agricultural research which has to be determined by national needs. If, in the past, science was pursued for its own sake, nowadays it is being asked whether national expenditure on scientific research can also be justified in economic terms. Agricultural research would seem to be a particularly suitable area for studying this question since it is largely publicly funded, and agricultural benefits tend to accrue to the community as a whole in its capacity as a consumer of food.     

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.     

The Politics of Technological Literacy

Technological literacy has been given official sanction; it is the end of technology education in the United States. For most technology educators, the construct is neutral, and something nobody could be ‘against’. This article situates technological literacy in its ideological context of competitive supremacy and conservative politics. In opposition to a ‘neutral’ notion of this construct, a turn toward critical technological literacy is negotiated. Critical technological literacy represents an overtly political turn toward overcoming forms of power that sustain inequities in the built world. To engage in these politics, it is argued that technology educators will necessarily have to resituate their practice within cultural studies. This revised version was published online in July 2006 with corrections to the Cover Date.     

A NEW PERSPECTIVE ON MULTIPLE INTERNAL RATES OF RETURN

The most commonly cited drawback to using the internal rate of return to evaluate deterministic cash flow streams is the possibility of multiple conflicting internal rates, or no internal rate at all. We claim, however, that contrary to current consensus, multiple or nonexistent internal rates are not contradictory, meaningless or invalid as rates of return. There is, moreover, no need to carefully examine a cash flow stream to rule out the possibility of multiple internal rates, or to throw out or ignore “unreasonable” rates. What we show is that when there are multiple (or even complex-valued) internal rates, each has a meaningful interpretation as a rate of return on its own underlying investment stream.It does not matter which rate is used to accept or reject the cash flow stream, as long as one identifies the underlying investment stream as a net investment or net borrowing. When we say it does not matter which rate is used, we mean that regardless of which rate is chosen, the cash-flow acceptance or rejection decision will be the same, and consistent with net present value.     

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.     

A review of: “THE CARELESS REVOLUTION”

Payback period is an important and widely-used measure of the economic attractiveness of an investment opportunity. It is an easy concept to understand and is readily computed by a variety of methods. The difficulty, however, is that these methods give misleading results. Nevertheless, payback period determination may be considered an effective intermediate step in the computation of the after-tax rate of return. The conversion techniques must, of necessity, be simple in order to encourage the use of rate of return as the decision criterion rather than payback period.

The relationships between payback period as defined here and rate of return are developed for both the before-tax and after-tax situations. If the tax consequences are to be considered, the tax rate and depreciation method must be known in addition to payback period and useful life. The equations derived for computing the rate of return are plotted for selected values of the parameters, and the resulting curves provide a simple means for determining the rate of return when the payback period is known.     

The myth of the unique decomposability: specializing the Herfindahl and entropy measures?

This research note investigates the trend towards specializing the Herfindahl index H for measuring industry concentration and the entropy measure E for expressing firm diversity. Examining the “decomposability” of E and H, we show that the professed overriding advantage of the entropy measure with respect to decomposability is not its exclusive preserve; the paper contains a proof that this property is also shared by the Herfindahl index. It is also shown that, due to its more stable range, the H index is more versatile with respect to inversion than the E measure. Strategy researchers are thereby cautioned that the current trend toward an increased use of entropy is risky and should be reassessed. Copyright © 1999 John Wiley & Sons, Ltd.     

Tying in Two‐Sided Markets with Multi‐Homing: Corrigendum and Comment

We identify two issues in Choi's [2010] paper on tying in two‐sided markets published in this Journal, and provide solutions to both of them. First, we point out that the equilibrium in the absence of tying requires more restrictive conditions and does not satisfy a natural equilibrium refinement criterion. We offer an alternative timing structure that validates the equilibrium derived in Choi [2010] under the conditions provided there. Second, we show that his equilibrium analysis with tying ignores a profitable deviation. We rectify this analysis under our alternative timing structure and derive the (mixed‐strategy) equilibrium with tying. We also show by means of simulations that tying is welfare‐enhancing whenever it is profitable, which is consistent with the main finding in Choi [2010].     

Do Article 22 exemptions adequately stimulate investments in European gas markets?

Stimulating investments whilst introducing competition is a major policy issue for European gas markets. The current Article 22 exemptions regime, which is an application to the gas market of the access holiday theory, is designed to address this issue. Though useful, the access holiday theory provides an incomplete picture. In order to adequately analyze the exemptions regime, this paper incorporates the real options theory of investments into the analysis. Combining both theories provides the properties of an exemptions regime that better stimulates investments in gas. The current exemptions regime has some shortcomings, in particular regarding its risk criterion. A better exemptions regime would grant less exemptions, but if it does, allows higher profits during the exemption. Revised version of a paper presented at the European Doctoral Seminar on Natural Gas, State University, Moscow, November 24, 2007. I would like to thank the participants, especially Martin Gilman and Franz Hubert, as well as Koen Caminada, Ben van Velthoven and a referee of this journal for their comments and suggestions.     

Gibrat's Law: Are the Services Different?

Several noted surveys on intra-industry dynamics have reached the conclusion from a large body of evidence that Gibrat's Law does not hold. However, almost all of these studies have been based on manufacturing or large scale services such as banking and insurance industries. There are compelling reasons to doubt whether these findings hold for small scale services such as the hospitality industries. In this paper we examine whether the basic tenet underlying Gibrat's Law– that growth rates are independent of firm size – can be rejected for the services as it has been for manufacturing. Based on a large sample of Dutch firms in the hospitality industries the evidence suggests that in most cases growth rates are independent of firm size. Validation of Gibrat's Law in some sub-sectors of the small scale services suggests that the dynamics of industrial organization for services may not simply mirror that for manufacturing. The present paper includes a survey of nearly 60 empirical studies on firm growth rates.     

Kitchen confidential? Norms for the use of transferred knowledge in gourmet cuisine

When will knowledge holders share their knowledge with peers? Several studies suggest that norms of knowledge disclosure encourage knowledge transfer. More recently, scholars have hypothesized that norms of knowledge use may indirectly promote it. In this article, we synthesize a theoretical framework of the effect of norms of knowledge use and test its predictions by means of a field experiment involving more than 500 Italian chefs. For the literature on knowledge transfer, we confirm the importance of norms, but we also show that they are not complete substitutes for other means of protecting private knowledge. For the literature on social norms, we provide evidence of how actors assess others' propensity to conform and how this influences the intention to participate in the norm‐regulated exchange. Copyright © 2013 John Wiley & Sons, Ltd.     

Prepurchase financing pool: Revealing the IRR problem

Internal rate of return (IRR) is one of the most common and important indicators in investment analysis because it is often used by managers and practitioners as a decision-making criterion. Moreover, the IRR reflects the financial cost in financing decisions and it helps to answer the following question when comparing different financing alternatives: “Which loan is the cheapest?” Among the different types of loans in Brazil, there is a financial product called a prepurchase financing pool (PPFP) that is generally regarded as the best option for financing or loans. The objective of this article is to use the prepurchase financing pool to show the flaws of IRR in financial analysis. In particular, when IRR is used to evaluate the prepurchase financing pool, one finds problems of reliability regarding (i) existence, (ii) uniqueness, and (iii) economic interpretation of the rate. The results show that the prepurchase financing pool is relevant evidence that the IRR flaws are found in financial products.     

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.