Net Present Value Rule Research Articles

Decision Rules for Corporate Investment

We investigate the decision rules for corporate investment by designing a company value frontier. This company value frontier allows for balancing the financial value and social and environmental impacts. This article develops novel value concepts—ranging from shareholder value to shareholder welfare and integrated value—resulting in varying preferences for social and environmental impacts or values. Next, these preferences are incorporated in investment decision rules. The traditional net present value (NPV) rule optimises only the financial value. We propose a new integrated present value (IPV) decision rule that includes a preference for social and environmental values without neglecting the financial value. By applying the new IPV rule, responsible companies are able to achieve more sustainable outcomes.

Shareholder theory, stakeholder theory, and the capital budgeting decision

This paper constructs a capital budgeting framework within which shareholder theory and stakeholder theory are complements, not substitutes. Shareholder theory focuses managerial attention on a single goal: the maximization of a firm’s long-term value. Stakeholder theory identifies the necessary prerequisites for long-term value maximization. In particular, to create long-term value for shareholders, a firm must first create value for current and future customers and employees, and it must not do so at the expense of the broader community, or society as a whole. The new model is unique in that encourages managers making capital budgeting decisions to explicitly consider tail risks, defined as events that, while unlikely, could have a significant impact on a firm’s operations and valuation. Within this framework, the net present value (NPV) rule provides an objective decision rule to constrain managerial discretion and to balance the interests of competing stakeholders in the project selection process.

In depth analysis of Fisher model and explore its limitation

This paper shows how people develop the concept of time value of money or the interest rate in the financial market model, how to derive individual savings decisions from corporate investment decisions, and why the net present value rule applies to decision-making. Specifically analyze the relationship between capital market line and Fisher model. And based on the Chinese stock market to further study the Fisher model and show its role.

The Valuation of Illiquid Assets: A Focus on Private Equity and Real Estate

This article reviews methods that can be used to value illiquid investments, focusing on private equity and real estate. The authors discuss the traditional valuation methods, particularly the net present value (NPV) rule, and show in what circumstances these can lead to suboptimal investment decisions. Emphasis is placed on a real option valuation framework that can alleviate some of the drawbacks of traditional approaches. A new jump-diffusion option pricing model and a numerical example are presented to show the usefulness of such a framework in valuing illiquid assets, in particular venture capital funds. They maintain that, under harmonized parameter estimation techniques, the NPV rule can be viewed as the lower bound in a competitive market and the real option exercise criteria and valuation models as providing the upper bound to value and time investments in illiquid assets. The knowledge of such bounds should enhance the decision-making process concerning allocating funds to alternative investments.

The valuation of buildings energy retrofitting: A multiple-criteria approach to reconcile cost-benefit trade-offs and energy savings

Directive 2018/844/EU promotes long-term renovation strategies to achieve the 2050 EU-wide energy and climate targets. As the building sector accounts for 40% of final energy consumption and 36% of CO2, buildings energy retrofitting and the valuation of related investments play a fundamental role in the successful implementation of the energy transition. The economic evaluation of buildings’ energy retrofit projects is usually performed by implementing the Life Cycle Cost approach. Nonetheless, due to increased social awareness and environmental concerns, homeowners may be willing to invest in more energy-efficient solutions, rather than in the least-cost solution. This paper aims to provide a valuation framework to identify cost-effective and cost-optimal strategies of intervention, which match technological innovation in buildings energy renovations with environmental concerns and social awareness. In detail, we complement the Life Cycle Cost method with the Net Present Value rule and determine the best retrofit project by implementing a two-criteria (i.e., reduction in primary energy consumption and increase in the present value of net benefits compared to the status quo), additive-value decision model. We also propose a graphical approach, which provides a straightforward identification of the best compromise solution between Net-Present-Value maximizing and energy-saving maximizing buildings’ energy retrofit projects. We tested the proposed approach on a real-world case study and found that it is less sensitive than other methodologies to uncertainty over discount rates and future energy prices.

Q-Factors and Investment CAPM

The Hou–Xue–Zhang <italic>q</italic>-factor model says that the expected return of an asset in excess of the risk-free rate is described by its sensitivities to the market factor, a size factor, an investment factor, and a return on equity (ROE) factor. Empirically, the <italic>q</italic>-factor model shows strong explanatory power and largely summarizes the cross-section of average stock returns. Most important, it fully subsumes the Fama–French 6-factor model in head-to-head spanning tests. The <italic>q</italic>-factor model is an empirical implementation of the investment-based capital asset pricing model (the Investment CAPM). The basic philosophy is to price risky assets from the perspective of their suppliers (firms), as opposed to their buyers (investors). Mathematically, the investment CAPM is a restatement of the net present value (NPV) rule in corporate finance. Intuitively, high investment relative to low expected profitability must imply low costs of capital, and low investment relative to high expected profitability must imply high costs of capital. In a multiperiod framework, if investment is high next period, the present value of cash flows from next period onward must be high. Consisting mostly of this next period present value, the benefits to investment this period must also be high. As such, high investment next period relative to current investment (high expected investment growth) must imply high costs of capital (to keep current investment low). As a disruptive innovation, the investment CAPM has broad-ranging implications for academic finance and asset management practice. First, the consumption CAPM, of which the classic Sharpe–Lintner CAPM is a special case, is conceptually incomplete. The crux is that it blindly focuses on the demand of risky assets, while abstracting from the supply altogether. Alas, anomalies are primarily relations between firm characteristics and expected returns. By focusing on the supply, the investment CAPM is the missing piece of equilibrium asset pricing. Second, the investment CAPM retains efficient markets, with cross-sectionally varying expected returns, depending on firms’ investment, profitability, and expected growth. As such, capital markets follow standard economic principles, in sharp contrast to the teachings of behavioral finance. Finally, the investment CAPM validates Graham and Dodd’s security analysis on equilibrium grounds, within efficient markets.

Sequential Investment and Time to Build

Real world investment decisions are generally made sequentially, over time. Management must consider the possibility of subsequent decisions like suspending a project when an initial investment decision is made. This consideration seems to be particularly important in the case of investments, which take a long time to build. In this paper, I analyze the impact of lags between the initial investment decision and the completion of the project. I also analyze in a dynamic setting under uncertainty the impact on the investment value of the option to suspend investment or operations and the investment threshold. I show that the standard net present value rule works well within my framework. This result contrasts with the main results in most of the real options literature. I use my model to value the length of permit procedures for locational decisions.

Managing risks from climate impacted hazards – The value of investment flexibility under uncertainty

Incomplete knowledge about climate change and the related uncertainty in climate prediction makes adaptation inherently difficult. We introduce a real options framework to determine the optimal adaptation to catastrophic risk that takes into account climate change uncertainty. The framework can be used to select the optimal adaptation project from a number of alternative projects or to determine the optimal investment sequence of the considered projects. In applying the model to the management of bushfire risk at a local government area, we find that the framework can significantly increase the value of adaptation investment, above the current net present value, and also improve upon deterministic dynamic models. We also find that it is important to consider sequential investment to preserve investment flexibility under the uncertainty of climate change. When decision makers can afford multiple investment projects, the loss associated with the use of a simple net present value rule can be substantial, and it is important to use a deterministic dynamic model or a real options model.

Terminal investment timing decisions in a competitive setting with uncertainty using a real option approach

ABSTRACTThis paper uses a real option approach to analyze terminal investment timing decisions for situations in which a port faces competition from its rivals in an uncertain market. We propose a network model to describe carriers’ cargo routing decisions and competition among rival ports. We then transform this model into a multicommodity flow problem and use the column generation algorithm to solve it. After obtaining a port’s possible future annual revenues and the potential net present value (NPV) for its terminal construction project through the network model, we adopt the expanded NPV rule and transform the investment timing decision into an optimal stopping problem. A least squares Monte Carlo simulation algorithm is proposed to find the investing probabilities for future years. The proposed models are applied to a steel cargo terminal investment case in the Port of Bengbu in Anhui province of China. The impacts on the investing probability and the expanded NPV of changes in the demand volatility, the initial investment and the port discharging rate are analyzed to provide managerial insights for port managers.

The impact of delaying an investment decision on R&D projects in real option game

In a research and development (R&D) investment, the cost and the project value of such an investment are usually uncertain, which thus increases its complexity. Correspondingly, the NPV (Net Present Value) rule fails to evaluate the value of this project exactly, because this method does not take into account the market uncertainty, irreversibility of investment and ability of delay entry. In this paper, we employ the real option theory to evaluate the project value of a R&D investment. Since the cost of a R&D investment is very high and the flow of the information is crowded, an investor cannot make an immediate decision every time. So, the proposed real option model is an exchange option. At the same time, combining the real option and the game theory, we can find the Nash equilibrium which is the optimal strategy. Moreover, we also study how the delayed time influences the price of the project investment and how the different delayed times effect the choice of the optimal strategies.

Managing for Value 2.0

In Finance 101, future corporate managers are taught that the social mission of public companies is to maximize their own longrun (or “intrinsic”) value by investing in all positive net present value (NPV) projects—that is, projects that are expected to earn at least their opportunity cost of capital. In markets that are reasonably efficient, provided management does an effective job of communicating its business plan and its progress in meeting its strategic goals, companies that follow this “NPV rule” can expect to be rewarded with increases in their share prices, at least in the longer run.But in the real world, of course, the pursuit of earnings and other “key performance indicators” (KPIs) often leads to managerial shortsightedness and destruction of value. To explain why—and to help companies avoid this outcome—this article presents an approach that envisions the intrinsic value of the company as an invisible “blue line” that moves through time on a graph, while showing observable key performance indicators, including revenue and earnings (and even the current stock price), as “red lines” on the same graph. The root of the problem is the failure of many companies to distinguish between their KPIs and the underlying drivers of value. KPIs, to be sure, are reflections of important aspects of the business; but however important and useful for strategic planning, they should not be used in performance evaluation or compensation plans for top management as surrogates for the underlying value of the business. Genuine value creation requires systems and a corporate culture that compel managers to pursue all projects that promise to earn the opportunity cost of capital—while treating earnings and other KPIs as means to creating value rather than ends in themselves.

Are short rotation coppices an economically interesting form of land use? A real options analysis

Short rotation coppice (SRC) is intensively discussed as being an economical and ecological advantageous alternative to traditional agricultural land use. In various countries, farmers have been encouraged through incentives to cultivate SRC. Nevertheless, they often do not switch from conventional land use to SRC, even if SRC is relatively beneficial according to the net present value (NPV) rule. Therefore, farmers do not follow the classical investment theory. A relatively new theory is the real options approach (ROA). The ROA takes further aspects like irreversibility of the investment costs, flexibility regarding investment timing, and uncertainty of the investment returns into account, which the NPV rule ignores. In the case of SRC, investment (conversion) triggers when a farmer should switch to SRC following the ROA can be higher than those following the NPV rule. As it is often the case in real options applications, decision makers’ possibility to disinvest in general and farmers’ possibility to reconvert, in particular within the useful lifetime of SRC, is not considered. We build a model to calculate the conversion triggers for switching from annual crop production to SRC following the ROA. We consider the opportunity to reconvert the land and evaluate the respective effects on the conversion triggers according to the ROA. Furthermore, we analyze the effect of a former governmental incentive, in terms of an investment subsidy, on the conversion triggers of both theories. Our calculations show that following the ROA, a farmer should change land use to SRC more slowly than when following the NPV rule. Furthermore, neglecting the reconversion possibility would cause considerable bias amongst the results. The consideration of investment subsidies diminishes the conversion triggers of both theories. We conclude that the ROA can at least partially explain farmers’ inertia of converting to SRC.

Options in technology investment games: The real world TFT-LCD industry case

The Thin Film Transistor-Liquid Crystal Display (TFT-LCD) industry has demonstrated that the investment of huge amounts of capital in new plants is a key factor for success. Decisions about investing in the latest generation of plant involve billions of dollars and a great deal of uncertainty. Moreover, the industry shows distinct oligopolistic characteristics, so the first mover's reactions must be considered when making capital decisions in such competitive environments. The traditional net present value (NPV) rule is a ‘now-or-never’ concept that fails to capture the need for managerial flexibility, which is especially important when investments are irreversible and involve a great deal of uncertainty. In this paper, we use a combination of real options and game theory to analyze the investment strategies of a case company in the TFT-LCD industry. The results show that real options reveal the value of flexibility, which NPV fails to consider. In addition, we apply game theory analysis to different investment strategies to demonstrate the decision-making processes used by competing companies.

Switching to Perennial Energy Crops Under Uncertainty and Costly Reversibility

We study a farmer's decision to convert traditional cropland into land for growing dedicated energy crops, taking into account sunk conversion costs and uncertainties in crop returns. The optimal decision rules differ significantly from the expected net present value rule, which ignores uncertainties, and from real options models that allow only one‐way conversion into energy crops. These models also predict drastically different patterns of land conversions into and out of energy crops over time. Using corn–soybean rotation and switchgrass as examples, we show that the model predictions are sensitive to assumptions about stochastic processes of the returns. Government policies might have unintended consequences: subsidizing conversion costs into switchgrass may not much affect proportions of land in switchgrass in the long run.

Rational Escalation: The Real Option Perspective

&lt;p class="MsoTitle" style="text-align: justify; line-height: normal; margin: 0in 0.5in 0pt;"&gt;&lt;span style="font-size: 10pt; font-weight: normal; mso-fareast-font-family: 'MS Mincho';"&gt;&lt;span style="font-family: Times New Roman;"&gt;Escalation is generally defined in investment context as continuation of an investment project after receiving negative signals about the outcome. This study demonstrates that under conditions of uncertainty about project outcome there is a rational incentive for the manager to continue a project to receive more information. Taking this real option on continuing the project has value for the firm. Simulations results from the option value model of investment demonstrate that likelihood of escalation is higher when signals have higher quality which increases the value of getting an additional signal. Likelihood of escalation also increases when the prior expectation of success is low, and when project termination cost is low. Continuing the project to receive additional information is shown to be more profitable than the simple net present value rule that excludes option value. The model implies that escalation may be value-maximizing for the firm, and managers should not automatically be discouraged to continue a project when new signals about its success may appear in the future.&lt;/span&gt;&lt;/span&gt;&lt;/p&gt;

Using EVA As A Decision Metric In Capital Budgeting

&lt;p class="MsoSubtitle" style="text-align: justify; line-height: normal; margin: 0in 0.5in 0pt;"&gt;&lt;span style="font-size: 10pt; font-weight: normal;"&gt;&lt;span style="font-family: Times New Roman;"&gt;Economic Value Added (EVA) has been growing in popularity within the business community as a measure of both value and performance.&lt;span style="mso-spacerun: yes;"&gt;&amp;nbsp; &lt;/span&gt;Despite this growth, EVA has yet to receive significant attention in the academic literature, particularly in micro decision-making areas such as capital budgeting.&lt;span style="mso-spacerun: yes;"&gt;&amp;nbsp; &lt;/span&gt;This paper examines the efficacy of EVA as a capital budgeting decision-making aid.&lt;span style="mso-spacerun: yes;"&gt;&amp;nbsp; &lt;/span&gt;Although a theoretical link between EVA and net present value (NPV) has been noted, issues related to its implementation have yet to be addressed.&lt;span style="mso-spacerun: yes;"&gt;&amp;nbsp; &lt;/span&gt;Our analysis details conditions under which EVA produces managerial decisions similar to those obtained by the NPV rule.&lt;span style="mso-spacerun: yes;"&gt;&amp;nbsp; &lt;/span&gt;Contrary to some claims, we find EVA and NPV produce different accept/reject decisions in a variety of commonly encountered capital budgeting situations.&lt;/span&gt;&lt;/span&gt;&lt;/p&gt;

Real Options Analysis and the Assumptions of Corporate Finance: A Non-Technical Review

This paper provides a non-technical presentation of the theoretical foundations of corporate financial decision making and the net present value (NPV) rule. Our objective is to show that the concepts of value and value creation arise from a single, unified framework that is firmly rooted in neoclassical microeconomic theory. This, in turn, allow us to demonstrate that the corporate valuation approach generically known as real options analysis is perfectly justifiable – without further qualification – in any situation when investors want managers to maximize NPV.

Yes, We Should Discount the Far-Distant Future at Its Lowest Possible Rate: A Resolution of the Weitzman–Gollier Puzzle

AbstractIn this paper the author proves that the Expected Net Future Value (ENFV) criterion can lead a risk neutral social planner to reject projects that increase expected utility. By contrast, the Expected Net Present Value (ENPV) rule correctly identifies the economic value of the project. While the ENFV increases with uncertainty over future interest rates, the expected utility decreases because of the planner’s desire to smooth consumption across time. This paper therefore shows that Weitzman (1998) is “right” and that, within his economy, the far-distant future should be discounted at its lowest possible rate.

Hyperbolic Discounting and Economic Policy

Economic policy-making often entails comparison between immediate costs and flows of future benefits or immediate benefits and series of future costs. Economics has a tool to handle such comparisons: the present- and future value calculations and the net present value rule. Experimental economics, however, has strongly criticised the method of exponential discounting applied in such calculations. Based on experiments for the sake of more psychological realism, they propose alternative methods to the exponential model: hyperbolic and quasi-hyperbolic discounting models.The present paper has a twofold objective: first, to review these different models and the relationships between them to show how the different models will yield different results when calculating and comparing present values of a single future payment, but even more if we compare present values of flows of future payments. The literature has not yet employed the hyperbolic and quasi-hyperbolic models for such calculations. Second, I point out why it is important to heed the findings of experimental economics especially in the field of economic policy-making.

Net Present Value-Consistent Investment Criteria Based on Accruals

In recent years, many firms have favoured residual income for value based management. One main argument for this measure is its identity with the net present value rule and that this compatibility with the net present value rule holds true for all possible depreciation schedules selected. In this article, we analyse whether there are other, undiscussed, accrual accounting numbers that enable net present value-consistent investment decisions for all possible depreciation schedules. Our analysis provides an if-and-only-if characterisation of the entire class of net present value-consistent investment criteria, based on accounting information. This provides new insights into the residual income concept, hurdle rates, opening and closing error conditions achieved by applying more common performance measure structures, and allocation rules. Moreover, our analysis shows the limits of constructing such investment criteria.