Reading: Foundations of NPV Rule

The previous section has introduced the NPV rule and shown how to apply this rule in different capital budgeting situations. We have argued that the NPV rule is a sensible decision criterion because it ensures that managers only take projects that generate more money than they cost (in terms of risk-adjusted present values) and thereby increase the financial value of the firm.

The purpose of this section is to show in a simplified setting that the NPV rule does indeed make investors better off and that it can help reconcile diverging interests among shareholders. Therefore, the NPV rule is an instrument tool in the toolbox of financial managers. However, it is important to add that the NPV rule is far from perfect. Especially for projects with large externalities (for example pollution of the environment), it is not clear that the NPV is the appropriate investment decision criterion because it tends to ignore important side-effects that lack a binding market price (such as carbon dioxide emissions). Therefore, managers should never blindly follow the NPV rule.

The section proceeds as follows:

• We start with a simple example that illustrates potential diverging interests between investors with different time preferences of consumption. 
• We show how well-functioning capital markets help to reconcile these differences.
• We discuss the main takeaways for financial managers.
• We caution financial managers to blindly use the NPV rule, as it tends to ignore or underrepresent important non-financial elements of projects.