Uses, Abuses, and Alternatives to the Net-Present-Value Rule

Ross, Stephen A.
September 1995
FM: The Journal of the Financial Management Association;Autumn1995, Vol. 24 Issue 3, p96
Academic Journal
This article argues that the merits of alternative rules, the modified versions of the net-present-value (NPV) rule, that seem to endure in practice despite their conflict with the NPV rule. For most investments, the usefulness of the NPV rule is severely limited. As a formal matter, it applies only in those cases where the investment opportunity instantly disappears if it is not immediately undertaken. In fact, the vast majority of investments have a not insignificant time period over which they may be undertaken, and this implies that they have an embedded optionality on their own valuation that is exercised when the initial investment is made. The caveat to the NPV must be taken seriously that it applies only in cases where an investment does not preclude some alternative investment, because every investment competes with itself delayed in time. It is not that the NPV rule is wrong, rather it is somewhat irrelevant, and at best, it must generally be modified to be useful. Because nearly all investments involve the option to undertake them when financing alternatives are more favorable, in general, the preferred way lo deal with such investment decisions is to treat them as serious options on the financing environment. As shown, when evaluating investments, optionality is ubiquitous and unavoidable. If modern finance is to have a practical and salutary impact on investment-decision making, it is now obliged to treat all major investment decisions as option pricing problems.


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