Why the NPV Criterion Does Not Maximize NPV

Abstract

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 where they conflict with the NPV criterion.

JEL Classification: G31