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Why the NPV Criterion does not Maximize NPV

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  • Elazar Berkovitch

Abstract

This article presents a theory of capital allocation that shows how the use of net present value (NPV) as an investment criterion leads to inefficient capital budgeting outcomes and how this criterion may be dominated by other capital budgeting criteria, like the internal rate of return and the profitability index. The essence of our theory is rooted in the mainstream paradigm of corporate finance: while firms use NPV to measure the addition to firm value from prospective projects, "classical" informational and agency considerations prevent it from implementing the optimal capital budgeting outcome. Our theory also identifies conditions when alternative criteria should be used. Finally, we characterize when direct monitoring through capital budgeting dominates compensation contracts in alleviating the agency problem. Copyright 2004, Oxford University Press.

Suggested Citation

  • Elazar Berkovitch, 2004. "Why the NPV Criterion does not Maximize NPV," The Review of Financial Studies, Society for Financial Studies, vol. 17(1), pages 239-255.
    • Handle: RePEc:oup:rfinst:v:17:y:2004:i:1:p:239-255
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    File URL: http://hdl.handle.net/10.1093/rfs/hhg023
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    Cited by:

    1. Antonio E. Bernardo & Hongbin Cai & Jiang Luo, 2009. "Motivating Entrepreneurial Activity in a Firm," The Review of Financial Studies, Society for Financial Studies, vol. 22(3), pages 1089-1118, March.
    2. Kim, Doyoung, 2006. "Capital budgeting for new projects: On the role of auditing in information acquisition," Journal of Accounting and Economics, Elsevier, vol. 41(3), pages 257-270, September.
    3. Milton Harris & Artur Raviv, 2005. "Allocation of Decision-making Authority," Review of Finance, Springer, vol. 9(3), pages 353-383, September.
    4. Roper, Andrew H. & Ruckes, Martin E., 2012. "Intertemporal capital budgeting," Journal of Banking & Finance, Elsevier, vol. 36(9), pages 2543-2551.
    5. Alessandro De Chiara & Elisabetta Iossa, 2019. "How to Set Budget Caps for Competitive Grants," CEIS Research Paper 448, Tor Vergata University, CEIS, revised 24 Jan 2019.
    6. Magni, Carlo Alberto & Marchioni, Andrea, 2020. "Average rates of return, working capital, and NPV-consistency in project appraisal: A sensitivity analysis approach," International Journal of Production Economics, Elsevier, vol. 229(C).
    7. De Chiara, Alessandro & Elizalde, Idoia & Manna, Ester & Segura-Moreiras, Adrian, 2021. "Car accidents in the age of robots," International Review of Law and Economics, Elsevier, vol. 68(C).
    8. Szydlowski, Martin, 2019. "Incentives, project choice, and dynamic multitasking," Theoretical Economics, Econometric Society, vol. 14(3), July.
    9. Bernardo, Antonio E & Luo, Jiang & Wang, James J.D., 2005. "A Theory of Socialistic Internal Capital Markets," University of California at Los Angeles, Anderson Graduate School of Management qt29x1966g, Anderson Graduate School of Management, UCLA.
    10. Jackson, Jerry, 2010. "Promoting energy efficiency investments with risk management decision tools," Energy Policy, Elsevier, vol. 38(8), pages 3865-3873, August.
    11. Tor Brunzell & Eva Liljeblom & Mika Vaihekoski, 2013. "Determinants of capital budgeting methods and hurdle rates in Nordic firms," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 53(1), pages 85-110, March.
    12. Bernardo, Antonio E. & Luo, Jiang & Wang, James J.D., 2006. "A theory of socialistic internal capital markets," Journal of Financial Economics, Elsevier, vol. 80(3), pages 485-509, June.
    13. Weber, Thomas A., 2014. "On the (non-)equivalence of IRR and NPV," Journal of Mathematical Economics, Elsevier, vol. 52(C), pages 25-39.
    14. Schmidbauer, Eric, 2019. "Budget selection when agents compete," Journal of Economic Behavior & Organization, Elsevier, vol. 158(C), pages 255-268.
    15. Robert Stretcher & Mary Funck & Steve Johnson, 2017. "Capital investment and non-constant marginal cost of capital," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 41(1), pages 27-50, January.
    16. Kjaerland, Frode, 2007. "A real option analysis of investments in hydropower--The case of Norway," Energy Policy, Elsevier, vol. 35(11), pages 5901-5908, November.
    17. Guthrie, Graeme, 2012. "Regulated prices and real options," Telecommunications Policy, Elsevier, vol. 36(8), pages 650-663.
    18. García, Diego, 2014. "Optimal contracts with privately informed agents and active principals," Journal of Corporate Finance, Elsevier, vol. 29(C), pages 695-709.
    19. Alfarisi, Omar, 2022. "Hubnomics: Chapter 1 - The World Biggest Challenges Solution," OSF Preprints dkfwy, Center for Open Science.
    20. Jacco Thijssen, 2010. "Irreversible investment and discounting: an arbitrage pricing approach," Annals of Finance, Springer, vol. 6(3), pages 295-315, July.
    21. Andrey Malenko, 2011. "Optimal Design of Internal Capital Markets," 2011 Meeting Papers 442, Society for Economic Dynamics.
    22. Gregorio Curello & Ludvig Sinander, 2020. "Screening for breakthroughs," Papers 2011.10090, arXiv.org, revised Feb 2024.

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