Net Present Value Rule Research Articles

Capital Budgeting and Compensation with Asymmetric
 Information and Moral Hazard

We consider optimal capital allocation and managerial compensation mechanisms for decentralized firms when division managers have an incentive to misrepresent project quality and to minimize privately costly but value-enhancing effort. We show that in the optimal mechanism firms always under invest in capital relative to a naive application of the net present value (NPV) rule. We make a number of novel cross-sectional predictions about the severity of the under investment problem and the composition of managerial compensation contracts. We also find that firms will optimally give greater performance-based pay (at the expense of fixed wages) to managers of higher quality projects to mitigate the incentive for managers to overstate project quality. Thus, managers may receive greater performance-based pay because they manage higher-quality projects, not that greater performance-based pay causes firm value to increase.

Investment and Abandonment Decisions with Uncertain Price and Cost

We analyze firms’ investment and abandonment decisions when both output price and investment cost change stochastically. The model allows for and makes endogenous the abandonment decision, thereby incorporating irreversibility. We show that the investment trigger may be much higher than the standard net present value rule suggests even when a substantial portion of the investment cost may be recovered. Further, we argue that the correlation between output price and investment costs significantly affects the effect of irreversibility on investment behavior. Empirical implications are discussed with extensive numerical illustrations, along with an application to the banking industry.

General trigger values of optimal investment

We consider a general real option model which allows finite values for all parameters influencing the value of waiting in case of uncertain and irreversible investment. We show that the traditional net present value rule and the commonly known Dixit–Pindyck approach are nested in the same general real option model and hence produce optimal investment decisions only in their specific scenario.

The measurement and management of risk in R&D and innovation

This paper focuses on the issue of risk in the R&D and innovation processes. It examines the degree of risk suggested by the four main streams of the literature. While risk has not been a major focus of the empirical literature, the results suggest that the vast majority of inventions are worth relatively little, while a small proportion are extremely valuable. The second part of the paper argues that the net present value rule may not be appropriate in the presence of high risk, and the R&D decision may require an optimal stopping rule, which gives very different results. Adopting an optimal stopping rule in the face of a normal distribution of annual gross returns, the lifetime distribution of returns are similar to those observed in the real world. In addition, it is possible to use the results to replicate the observed behaviour of patent renewals.

Simple Analytics of Valuing Producing Petroleum Reserves

We modify the approach to valuing mineral reserves that is current in economic literature by considering a net present-value rule under uncertainty. Direct application of Hotelling's rule is found to be inappropriate. The modification is such that the present value is approximately half that proposed by the Hotelling Valuation Principle.

A Simple Approach for Deciding When to Invest

A straightforward generalization of the simple net present value rule that correctly predicts when to invest in two classes of projects that can be delayed is derived. The first class consists of projects for which the option to delay derives its value exclusively from uncertainty about interest rates. It is shown that the optimal rule for investing in such projects is to simply multiply the discount rate of the project by the ratio of the mortgage rate to the riskless rate and then use this new rate as the discount rate in a standard net present value analysis. The other class of investment opportunities that is considered is the firm's option to expand. It is shown that it is only optimal for the firm to expand when a particular call option on the firm's stock has no time value. The fact that mortgage bonds (in the form of GNMAs) and stock options are actively traded implies that these rules have potentially important practical and empirical value. Besides their simplicity, the rules have the added advantage that they do not depend on a maintained assumption on the dynamics of interest rates in the economy.

General Trigger Values of Optimal Investment

We consider a general real option model which allows finite values for all parameters influencing the value of waiting in case of uncertain and irreversible investment. We show that the traditional net present value rule and the commonly known Dixit-Pindyck approach are nested in the same general real option model and hence produce optimal investment decisions only in their specific scenario.

Can we reconcile finance with nature?

T he unanimity principle that underlies financial decision-making rules is ethically unacceptable and empirically invalid. Ecological sustainability requires radically different decision rules. This paper discusses three possible methods: life cycle analysis; full cost (or total cost) accounting; and non-quantitative accountability. Once decision-makers abandon the unrealistic and invalid assumptions of the unanimity models, no theoretically correct model is possible. Since they must still make decisions, the paper proposes combining life cycle analysis with the traditional net present value rule, as a practical alternative that should move toward sustainability.

The economic explanation of the strategy of a self financing firm during the recession period

The models of Johansen (1959), Nickell (1974, 1975) and Leban and Lesourne (1983) examine the reaction of a firm during the recession period. The firm can regulate investment, recruitment and firing. The formulation and mathematical solution of the model is well known. We analyse the development of the price variables and the co-state variables. Using the results of Feichtinger and Hartl (1986) and Van Hilten (1990) we describe the economic interpretation of the jump. Referring to Verheyen (1978, 1992) and Kort (1990) the conclusion is that the net present value rule (NPV) can explain the jump in the price variables of investment and recruitment and the moment of the postponement of the decisions. Therefore we formulate the NPV in the dynamic theory of the firm and we present a strategy during the recession period and a theoretical foundation of this rule of thumb, also usable in complicated situations.

Corporate Financial Decision Making in Canada

AbstractThis paper presents the results of a survey of chief executive officers and chief financial officers of large Canadian companies. We report on the state of corporate financial decision making in Canada, based on responses of 133 respondents.Our results indicate that most surveyed firms follow standardized methods of capital budgeting, with internal rate of return and payback period dominating the net present value method. However, forecasting methods are still dominated by subjective management estimates and expert opinions. Consensus rather than mathematical modelling seems to be the norm. Although the weighted average cost of capital seems to be the preferred discount rate in evaluating investment decisions, about 25 percent of the firms, including some public firms, use cost of debt as their cost of capital. The determination of cost of equity capital still seems to be mainly judgemental, followed closely by the use of accounting rates of return. A surprisingly low number of firms indicate the use of theoretical models such as the CAPM or the dividend growth model in the estimation process. Cost of financing continues to be a concern for Canadian firms and there is an overall perception that the cost of financing is high irrespective of the source of financing.Our overall results indicate that significant challenges lie ahead for corporate management in Canada and its ability to be internationally competitive. In spite of the well‐developed capital markets, executives in our survey indicate a disturbingly high perceived differential between the cost of internal and external financing, and a very low use of analytical methods.RésuméLes auteurs présentent les résultats d'un sondage auprès de chefs d'entreprises et de chefs de services financiers d'importantes compagnies canadiennes. Ils font état des décisions financières prises au Canada d'après les réponses au sondage de 133 répondants.Les résultats indiquent que la plupart des compagnies répondant au sondage utilisent des méthodes d'établissement de budget des investissements standardisés. Les méthodes du taux de rendement interne et de période de récupération dominent sur la méthode de la valeur actualisée nette. De plus, les méthodes de prévision sont encore dominées par l'opinion subjective des gestionnaires et les opinions des experts. La norme semble ětre le consensus au lieu de l'utilisation des moděles mathématiques. La méthode du coǔt moyen pondéré semble ětre la méthode préférée du coǔt du capital, mais, auprès de presque 25% des compagnies, incluant certaines compagnies publiques, le coǔt des frais d'emprunt comme leur coǔt du capital est utilisé. Le calcul du coǔt du capital semble encore ětre calculé d'une façon subjective suivi de très près par l'utilisation du taux de rendement comptable. Un montant peu élevé de compagnies se servent de modèles théoriques tel que le modèle d'équilibre des marchés financiers ou du modèle de croissance des dividendes dans le processus d'estimation. Le coǔt du financement semble ětre une préoccupation pour les compagnies canadiennes et la perception générale est que le coǔt du financement demeure haut, indpendamment de la source de financement.Les résultats globaux indiquent qu'il y aura un défi important à relever pour les gestionnaires de compagnies au Canada ainsi que leurs habiletés à demeurer compétitifs sur le plan international. En dépit des marchés financiers bien développés, les cadres dans notre sondage ont indiqués un différentiel très élevé entre le coǔt de financement interne et externe, ainsi qu'une faible utilisation des méthodes analytiques.

Splitting the firm between the entrepreneur and the venture capitalist with the help of stock options

The Net Present Value (NPV) Rule provides the basic principle underlying the sharing of ownership in a new venture. The principle often fails because the entrepreneur and the venture capitalist cannot agree on the potential profitability value of the venture. First, the venture capitalist may simply have a less optimistic interpretation of the data related to the venture's profit potential. We refer to this discrepancy between the expectation of the entrepreneur and that of the venture capitalist as the expectation gap. Second, the venture capitalist knows that for the venture's potential to be realized, the entrepreneur/manager must devote his full effort to the success of the organization. This is not a problem if the entrepreneur owns the entire project. Once the ownership is shared, however, especially when the venture capitalists own the majority of the shares, the entrepreneur has a financial incentive to apply less than the diligence required to control costs and protect the interests of the outside equity holders. This financial incentive arises because any perk, including leisure or shirking, consumed by the entrepreneur does not have to be shared with the venture capitalist, while every dollar saved does. This is not solved by the venture capitalist acquiring a larger percentage of the company. That will only exacerbate the problem as it decreases the cost to the entrepreneur of each dollar of the company's funds spent for the perk. We refer to this as the motivation problem. In the article, we show how stock options can be used to deal effectively with both problems. First, stock options are always worth more to the optimist than to the pessimist. Thus, there will be a reverse valuation gap with respect to the stock options. We show that by issuing stock options to the entrepreneur, it is possible to close the expectation gap. To solve the motivation problem, the entrepreneur's stake must be increased to the extent where the cost to him of excessive consumption of perks will be as high as the benefit he derives. This can be accomplished by taking advantage of two valuation characteristics of stock options. First, stock options are worth only a fraction of the value of the underlying equity shares. Thus, it is easier for the venture capitalist to give up these, rather than the underlying equity shares. Second, the stock options will fluctuate with the venturing firm's value at a higher rate than the entrepreneur's percentage ownership. Thus, by issuing the entrepreneur a combination of equity shares and stock options, it is possible to increase significantly the entrepreneur's cost of “shirking” or “excessive consumption of perks.” Under idealized conditions, it is possible to design a financing arrangement that eliminates the motivation problem. The principles discussed here provide benchmarks that both the entrepreneur and the venture capitalist may wish to bring to the negotiating table. In the end, there is no substitute for the building of trust between the two to give the venture the maximum chance of success.

Reputation, Information and Project Termination in Capital Budgeting

ABSTRACT The Net Present Value (NPV) rule of financial theory gives management a decisive criterion for choosing between abandonment versus continuation of capital projects. There is extensive evidence, however, that management chooses to delay the abandonment of unprofitable projects. This paper attempts to explain management's reluctance to abide by the NPV criterion. The concept of a Reputation Adjusted Net Present Value is introduced in an environment where management knows more about the true value of a project than do stakeholders. The model indicates that, in such an environment, the continuation of a negative NPV project may maximize firm value.

Rate of Return and Optimal Investment in an Imperfect Capital Market

The analysis of a firm's investment decision under certainty involves two basic topics: The determination of the optimal initial total invest ment and the selection of investment projects among alternatives. Following the suggestion first made by Keynes (pp. 135-146), the optimal level of total initial investment is determined by the intersection of marginal efficiency of investment (MEI) and marginal cost of capital (MCC) curves. Hirshleifer promoted an alternative approach. In his 1958 paper, he extended Fisher's idea of the inter temporal allocation of investment funds between two periods. Essential to this approach is the concept of productive and market opportunity curves. If, in addition, the decision unit is assumed to possess a conventional preference function, it can also determine the optimal income and consumption pattern over time. This two-stage procedure of first maximizing invest ment return and then consumption is known as Fisher's Separation Theorem. In order to implement either one of these two approaches, it is necessary to evaluate the rates of return from all feasible investment projects and rank them properly. The current economic literature, however, does not satisfactorily address the question of how to measure investment returns. Two commonly used tech niques are net present value (NPV) and internal rate of return (IRR). The NPV technique, which measures projects by magnitudes instead of rates, disengages itself from the aforesaid investment decision theories. In fact, ranking investment projects by NPVs favors those with large initial outlays. It can lead to erroneous investment decisions if the firm's borrowing capacity is limited at the given cost of capital. On the other hand, the IRR method is beset by its questionable reinvestment assumption and the possibility of multiple rates. Most of these problems were documented, for example, by Brigham (pp. 309-444), McGuigan and Moyer (pp. 494-517), and Solomon, to mention just a few. McGuigan and Moyer (pp. 497) warned that there are some practical difficulties in implementing the Keynesian approach. The basic problem lies in ranking the n-period investment projects and deriving the MEI curve. The same problem would arise with the introduction of Hirshleifer's approach. In such a case, the difficulty would be ranking the projects and deriving the productive opportunity curve. The purpose of this paper is two-fold. The authors propose a generalized rate of return concept designed to evaluate the rates of return from alternative investment projects in an imperfect capital market. Based on these rates of return, the decision maker can rank investment projects properly and perform the analysis of optimal total initial investment along the lines suggested by Keynes or Hirshleifer. In this paper we consider multi-period (N >: 2) investment projects in an imperfect capital market. There are no stringent assumptions imposed on the cash flow pattern of the investment projects, as was the case in the studies by Canton and Lippman, and Dorfman. Our emphasis has been on methods of determin ing the optimal total investment and consump tion in the initial period. As such, it is consistent with the general treatment of the subject in the current literature, but is less ambitious than what was attempted by Hirshleifer (pp. 200-205): Ascertaining optimal investment and consump tion in each and every period. In his analysis, the use of the NPV rule was shown to be not utility-free and a filtering procedure was sug gested to define the opportunity frontier. In section II, the concept of a generalized rate of return is introduced. This rate of return is

A dynamic net present value rule in a financial adjustment cost model

AbstractA dynamic model of a self‐financing firm is presented in which a convex adjustment cost function is incorporated. The horizon date is assumed to be infinite. It turns out that the concept of ‘net present value of marginal investment’ is a useful tool to develop the firm's optimal investment policy. When this net present value is positive, negative or zero, it is optimal for the firm to fix the investment rate at its maximum level, minimum level or equilibrium level respectively.

Project Exit Value as a Measure of Flexibility and Risk Exposure

ABSTRACT In applications of the classic methods of capital budgeting the emphasis has always been on the decision to “enter” a project, i.e., to select the project(s) to be executed. Although this decision remains a very important one, it is important to examine the decision to “exit a project”. When should one get out of a project or what are the financial consequences of a premature termination of an investment project? This paper introduces an extended version of the net present value rule for exit calculations. The impact of premature termination of a project can be graphed and forms the exit economic profile for the “life—cycle” of the project. This allows the investor to quantify the economic consequences of exiting the project at different points in time providing a measure of the risks involved in terminating or exiting a project. This type of analysis is particularly important for projects that face environmental uncertainty or those that may be terminated prematurely for example by technology, strategic flexibility, and government expropriation or other forces beyond the company's control.

SAFETY MARGINS AND CAPITAL BUDGETING CRITERIA

Textbooks often portray capital budgeting as a rather mechanical process: Top management decides whether or not to accept a project by requesting an estimate of net present value from its staff and to see if the number is positive or negative. This paper suggests that the textbook net present value rule is not optimal if the competitive market assumption holds. Better decision rules state minimum acceptable safety margins and may take the form of stating a minimum acceptable profitability ratio.

The Net Present Value Rule and an Algorithm for Maintaining a Constant Debt-Equity Ratio

The Net Present Value Rule and an Algorithm for Maintaining a Constant Debt-Equity Ratio

Performance Monitoring and the Timing of Cash Flows

* Theoretically, it is net present value, and not the pattern of cash flows over time, that is important to investors. This is true not only for capital expenditure decisions, but also for financing and dividend decisions. However, for the net present value rule to work as theory says it should, the present value of all costs and benefits must be incorporated in the analysis. This includes the costs and benefits of information-gathering and performance-monitoring activities. This paper discusses some possible reasons why firms often appear to disregard the net present value criterion. For instance, management often seems to weigh heavily the pattern and timing of a potential project's cash flows, and to make investment decisions based on the early arrival of these cash flows. A related issue is the firm's dividend decision: it is unclear why management agonizes over, and investors express a

Optimal Sequential Investment When Capital is Not Readily Reversible

When investment opportunities arrive one at a time and are reviewed sequentially, a corporation's optimal policy differs from a standard net present value rule if the corporation exercises control over an industry state variable and control is costly. The first condition presupposes a degree of market power for the firm; the second occurs if corporate investment decisions are imperfectly reversible. To address the problem of optimal investment in this context, a firm's investment decisions are modeled as a Markov reward process. The causes of economic irreversibility are discussed and general propositions concerning the optimal investment policy are derived. These propositions are then applied to the optimization of an exploration program by an oligopolistic firm (a price leader). Under particular demand and distributional assumptions, solutions for the optimal decision rule and the value of the exploration program are obtained and their properties examined.

Optimal Sequential Investment When Capital is Not Readily Reversible

ABSTRACTWhen investment opportunities arrive one at a time and are reviewed sequentially, a corporation's optimal policy differs from a standard net present value rule if the corporation exercises control over an industry state variable and control is costly. The first condition presupposes a degree of market power for the firm; the second occurs if corporate investment decisions are imperfectly reversible.To address the problem of optimal investment in this context, a firm's investment decisions are modeled as a Markov reward process. The causes of economic irreversibility are discussed and general propositions concerning the optimal investment policy are derived. These propositions are then applied to the optimization of an exploration program by an oligopolistic firm (a price leader). Under particular demand and distributional assumptions, solutions for the optimal decision rule and the value of the exploration program are obtained and their properties examined.