IDEAS home Printed from https://ideas.repec.org/a/oup/rfinst/v17y2004i1p239-255.html
   My bibliography  Save this article

Why the NPV Criterion does not Maximize NPV

Author

Listed:
  • 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
    as

    Download full text from publisher

    File URL: http://hdl.handle.net/10.1093/rfs/hhg023
    Download Restriction: Access to full text is restricted to subscribers.
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. 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.
    2. Jackson, Jerry, 2010. "Promoting energy efficiency investments with risk management decision tools," Energy Policy, Elsevier, vol. 38(8), pages 3865-3873, August.
    3. 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.
    4. 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.
    5. 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.
    6. Weber, Thomas A., 2014. "On the (non-)equivalence of IRR and NPV," Journal of Mathematical Economics, Elsevier, vol. 52(C), pages 25-39.
    7. Szydlowski, Martin, 2019. "Incentives, project choice, and dynamic multitasking," Theoretical Economics, Econometric Society, vol. 14(3), July.
    8. Schmidbauer, Eric, 2019. "Budget selection when agents compete," Journal of Economic Behavior & Organization, Elsevier, vol. 158(C), pages 255-268.
    9. 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.
    10. Milton Harris & Artur Raviv, 2005. "Allocation of Decision-making Authority," Review of Finance, Springer, vol. 9(3), pages 353-383, September.
    11. 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.
    12. 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.
    13. Guthrie, Graeme, 2012. "Regulated prices and real options," Telecommunications Policy, Elsevier, vol. 36(8), pages 650-663.
    14. García, Diego, 2014. "Optimal contracts with privately informed agents and active principals," Journal of Corporate Finance, Elsevier, vol. 29(C), pages 695-709.
    15. Roper, Andrew H. & Ruckes, Martin E., 2012. "Intertemporal capital budgeting," Journal of Banking & Finance, Elsevier, vol. 36(9), pages 2543-2551.
    16. Alfarisi, Omar, 2022. "Hubnomics: Chapter 1 - The World Biggest Challenges Solution," OSF Preprints dkfwy, Center for Open Science.
    17. 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.
    18. 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).
    19. Jacco Thijssen, 2010. "Irreversible investment and discounting: an arbitrage pricing approach," Annals of Finance, Springer, vol. 6(3), pages 295-315, July.
    20. 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).
    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.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:oup:rfinst:v:17:y:2004:i:1:p:239-255. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    We have no bibliographic references for this item. You can help adding them by using this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Oxford University Press (email available below). General contact details of provider: https://edirc.repec.org/data/sfsssea.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.