Lindon Robison's research is shifting the focus of an age-old discussion in economics.
January 11, 2016
Lindon Robison’s research is shifting the focus of an age-old discussion in economics.
“It’s absolutely simple,” said Robison, a professor in AFRE.
For years, people choosing between two investments could use two criteria to inform which one they chose: a percentage measure called internal rate of return (IRR) and a dollar measure called net present value (NPV). The numbers’ purpose is to show which of two investments will give the better return.
Until now, though, there’s been a caveat: depending on how they were calculated, the numbers could give conflicting answers. Two criteria with the aim of simplifying investment ranking frequently did the exact opposite.
Economists have searched for ways to make the two values match for decades, Robison said. Robison’s research, co-authored with Peter J. Barry and Robert J. Myers, proves that the issue is not with the criteria themselves but with the conditions that surround them.
“Instead of arguing about IRR or NPV to rank investment, what we really should be discussing is what set of conditions should we adopt to ensure that we get consistent rankings,” Robison explained.
He used a metaphor to explain the problem.
In a horse race, the two horses represent competing investments, and two judges represent NPV and IRR.
“The horses run the race, and one judge says horse A won, and the other judge says horse B won. They go back and forth and so on, so it’s a conflict. What we showed was that there are ways to get the judges to give the same ranking,” he said.
Robison’s article identifies two conditions needed to achieve consistent IRR and NPV rankings: differences in initial investment sizes must be eliminated, and all cash flows should be reinvested until the investment’s last period.
The article outlines various methods to satisfy these conditions. It also provides guidelines to help investors decide which methods to use depending on the characteristics of the considered investments. The investor chooses the methods that fit his/her particular situation. When those methods are used consistently, NPV and IRR will always suggest the same thing.
“If you tell two judges at the horse race, ‘This is how you evaluate it,’ they’ll both agree, but if you say, ‘No, evaluate it this way,’ they may still agree, but it may be a different horse,” Robison said.
This is an entirely new approach for economists, Robison said.
“It’s a big, big deal.”
Robison’s research isn’t exactly a crystal ball—figuring out which investment is best still requires some informed guesswork and decision making by the investor. But it does help to eliminate unnecessary uncertainty.
“We can give you the right method, but we can’t say, ‘Now your problems are done,’” Robison said. “Making investment decisions is complicated and uncertain, but at least what I can say is ‘Here are the processes or the methods that you use.’”
Robison has incorporated the technique into his teaching. In Agribusiness Management 435, a capstone course, one project requires student teams to analyze investments with this approach.
The study, "Consistent IRR and NPV Rankings" by Lindon J. Robison, Peter J. Barry and Robert J. Myers, appeared in the Agricultural Finance Review (74(4):499-513).