Skip to main content

Annualised Value Investment Ratio - AVIR

 The purpose of this post is solely to protect my Intellectual Property Rights (IPR) if ever there arises a situation where I need to prove the novelty of my work.

The post will not be structured. It is going to be a copy-paste operation. The only purpose is to document and date my idea.

I first developed this idea in early 2020. I then developed it further in August 2023. Vinay helped me throughout this process. 

Very briefly, AVIR or Annualised Value Investment Ratio (AVIR) is a capital budgeting metric that will help rank projects of different sizes and durations. Every common metric that exists now, like NPV, IRR, PI, EAB, etc.. suffers from one or more major flaws and my contention is that AVIR addresses these flaws and is the most superior metric available.

The copy paste starts now.


1. What is Annualised Value Investment Ratio (AVIR)? How is it different from VIR?

Ans: VIR is the discounted value generated per dollar (discounted) invested. AVIR takes this a step further and is the discounted value generated per dollar (discounted) invested per year (discounted). This ensures that, unlike VIR, AVIR is directly comparable for projects of different durations.


2. Okay. But what exactly does AVIR represent? 

Ans: The AVIR of the project is the excess annual return over and above the cost of capital.


3. I am beginning to get a sense of what AVIR represents. But can you explain it more mathematically? For example, what does an AVIR of 7% mean?

Ans: The AVIR of a project is the excess rate of annual return over and above the cost of the capital that will result in the same NPV as the reference project.


4. Can you please share an example?

Ans: Sure! As can be seen from Illustration 1, adding AVIR cashflows to the cost of capital cashflows each year results in the same NPV as the original cashflows of the reference project.


5. But does excess return over cost of capital not simply mean IRR less cost of capital, since IRR is essentially the annual rate of return?

Ans. That is not true. IRR is merely the discount rate which would result in the net present value of all cash flows to be exactly zero.


6. Are you sure? Can you prove that IRR is not annual rate of return?

Ans: Of course! In Illustration 2, you can see that annual return at the rate of IRR does not result in the same NPV as the reference project. In fact, this is one of the reasons why IRR is not a perfect metric for ranking projects. 

In fact, for a positive NPV project, the NPV when annual returns at IRR are discounted will always be greater than or equal to the NPV of the original project. This is because IRR assumes reinvestment at IRR itself. AVIR  addresses this limitation of IRR.


7. Does AVIR also work for projects with multiple years of cash outflows? Can you provide an example?

Ans: It certainly does. In fact, AVIR will work for any pattern of cash flows as long as there is at least one cash outflow. This robustness of AVIR renders it to be an excellent ranking metric for projects of different sizes, shapes, and duration. 

As can be seen in Illustration 3, which has multiple years of cash outflows, the sum of AVIR and cost of capital cashflows results in exactly the same NPV as that of the reference project.


8. If IRR assumes reinvestment at IRR itself, what rate of reinvestment does AVIR assume? How does it compare to the rate of reinvestment assumed by IRR?

Ans: VIR assumes reinvestment at the rate of cost of capital, hence resulting in zero incremental value being generated. This is too conservative an assumption and is also unreasonable since Shell requires a return above cost of capital which is the reason why the VIR threshold and the ranking mechanisms exist in the first place.

IRR assumes reinvestment at the rate of IRR itself. Often, this is too aggressive and unrealistic an assumption.

AVIR takes the middle path and assumes that the project of the same size can be replicated at the same IRR and the excess cash flow generated can be reinvested at cost of capital. This means that the overall reinvestment rate assumed by AVIR always falls between the two extremes of aggressive IRR and conservative VIR.











Comments

Post a Comment

Popular posts from this blog

VVS. Laxman - A Tribute

Published on Sportscafe The 8-0 continues to haunt us and i guess it will keep haunting us for some time to come. It is always sad when a sportsman retires. These are people in the prime of their lives suddenly having to give up not only what they are best at but often the only thing they know. “This series was meant to be a fitting final trophy but has ended in tears. An era is over in more ways than one. So after all the misery and rage, Indian cricket fans will perhaps tune in to the Adelaide Test not hoping for a turnaround – the time for that has long passed – but for a final glimpse of their batting heroes. Who knows how many of them will turn up at the next Test?” This was Sambit Bal before the Adelaide Test. How prophetic these words seem now. The 8-0 has claimed two of Indian cricket's biggest stalwarts. To be honest, this was always going to be inevitable. It was always a matter of ‘When’ rather than ‘If’. Hard to blame the selectors or MSD here. Having said...
1 comment
Read more

The Ascent to Sandakphu

IndiaHikes - Sandakphu Man originated somewhere deep in the jungles of Ethiopia. And then, he walked, and walked, and walked; to become, arguably, the most dominant species in the history of the planet. Walking then, is the most natural thing in the world, and as old as the hills themselves. And yet, today, walking is an archaism. We live in the era of Uber and Amazon, of the remote and the elevator; all designed to not just make walking unnecessary but also unfashionable. Trekking then, inhabits this curious corner of contradiction, natural and unnatural at the very same time. For the first time trekker, this contradiction is all the more magnified; accustomed as he is, to the warm comforts of luxury travel, the lure and excitement of trekking is nonetheless elementary, almost primal even. As the first timer treks, flat terrain is his friend, all so familiar and so very comforting; if at all, monotony is the only damper. The descent is a trickier beast, with dangers potenti...
Post a Comment
Read more

Sporting Immortality: Tendulkar's 6 off Akthar, Centurion, 2003 World Cup

Sport is meant to be a celebration of life, an embodiment of the ideal and the representation of the best in man. Stripped of fancy words and trite pretensions, Sport is but a contest between individuals; a contest to be faster, a contest to be higher, and a contest to be stronger; simply, a contest to be better. In cricket, the contest is between bat and ball; between the batsman and the bowler! A battle for supremacy. 35 yards.  In Mumbai, you can fit about 40 families into a space of 35*35 yards. Shoaib Akthar’s run up is 35 yards long. The batsman is a further 22 yards away. At that distance, the previous delivery is merely a memory and the coming delivery an expectation.  Shoaib Akthar starts his run up. Head down. Hair trailing. Then, he picks up pace. The trot becomes a run. He starts to look up, the hair is flying now. The image begins to blur. The crowd is on its feet. It’s a crescendo of noise. He’s not that far away now. The batsman awaits. He is alive, ...
Post a Comment
Read more