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

Abstract

Discounted methods are broadly applied to evaluate the effectiveness of investment projects. These methods do not pose difficulty calculating and interpreting their outcome as long as the NPV function is monotonic. However, the lack of monotonicity of this function creates obstacles to efficient applications of the mentioned methods. 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 discounted methods the said modifications lead to an erroneous 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.

DOI: http://dx.doi.org/10.5755/j01.ee.27.1.6334