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In this article, we show plausible situations
where the Net Present Value (NPV) criterion leads to inefficient capital
budgeting outcomes and is dominated by other capital budgeting criteria,
like the internal rate of return (IRR) and the profitability index (PI).
Our theory is rooted in the mainstream paradigm of corporate finance:
Firms use NPV to measure the addition to firm value from prospective projects,
but because of "classical" informational and agency considerations, NPV
is not the capital budgeting criterion that implements the best possible
outcome. We show that the IRR and PI are useful in curbing empire-building
managers because, when selecting between mutually exclusive projects, they
tend to bias against large-scale projects. Interestingly, they implement
a better outcome in exactly the situations that finance textbooks critize
their usefulness as capital budgeting criteria since they provide conflicting
conclusion from the NPV criterion. |
