Reading: Foundations of NPV Rule

Last but not least, we need to be careful about so-called "externalities" when applying the NPV rule. As we discuss in greater detail in the module Project Valuation, the standard NPV approach assumes that the cash flows that enter the valuation model are measured after all relevant stakeholders except for the investors have received a fair compensation. Put differently, the cash flows express how much cash a project generates, after all the "input factors" have received their fair market rate:

• The necessary investments have been made;
• Suppliers have been paid;
• Employees have received a fair salary;
• Taxes have been paid;
• etc.

Because all other stakeholders have received their fair compensation, what's left belongs to the investors. This is why shareholders are often said to have a residual claim. By pursuing a strategy that maximizes the NPV, we make sure that all stakeholders keep receiving their fair compensation and shareholders maximize their residual claim. Such a strategy should contribute to a more efficient allocation of resource and thereby increase social welfare. This is, in a nutshell, how the neoclassical argument behind "shareholder value maximization" goes.

Unfortunately, it is not that simple in reality. Two of the major implementation challenges are that it is not always easy to identify the "relevant stakeholders" and that it is often far from clear what the "fair" compensation is. Let us look at a few examples to illustrate this point:

• Consider a single mom who lives in a place with only one large employer. She might be so dependent on the job that the employer could pressure her into accepting a salary that is far below what would be considered "fair" based on her education and experience. By squeezing her salary, the residual claim for the shareholders goes up and, technically, the NPV could increase (at least in the short run). Such a strategy that "exploits" specific groups of stakeholders and redistributes wealth to shareholders is clearly NOT what we have in mind when advocating the NPV rule. 
   
• And then there are stakeholders who often do not have a voice, most prominently the environment. Standard NPV calculations generally ignore environmental concerns simply because there is no binding market price for pollution and other side effects on the environment. Take the case of a taxi company. When deciding about what cars to purchase, the choice could be between electric cars and cars with conventional gas engines. How to account for the fact that the electric cars have much smaller carbon dioxide emissions? While almost everybody agrees that carbon dioxide emissions are bad for the environment, there are no binding regulations that force firms to directly pay for these emissions. Therefore, they usually do not enter standard NPV calculations.

With such market imperfections, it is no longer clear that the NPV rule delivers an investment policy that treats all stakeholders fairly and allows shareholders to earn an adequate return. The implication is that in almost all situations, managers should refrain from blindly following the NPV rule. Instead, they should acknowledge that the standard NPV calculation often tends to ignore (or at least insufficiently reflect) important non-financial aspects of a project. These aspects should be made transparent to the decision maker so that they can be incorporated in the decision making process. Because market prices are often missing for this part of the analysis, it is generally more of an "art" than a "science."

To tackle this challenge, project managers could apply a two-pronged approach:

• Present the financial economics of the project in a NPV-framework as outlined above.
   
• Show the project's contributes to dimensions and goals that cannot be expressed in purely financial terms. For example, one could use the 17 Sustainable Development Goals (SDG) proposed by the United Nations, and discuss why and how the project has a positive impact on these goals.

The SDG are broadly formulated global goals that tackle the major environmental, social, and governance (ESG) challenges:

Such a two-pronged approach contributes to a better understanding and transparency of the project's potential sources of financial and non-financial value added.