Capital Budgeting Exception to NPV

Capital Budgeting Exception to NPV - Issues in Accounting...

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Issues in Accounting Education Vol. 13, No. 3 August 1998 Capital Budgeting: Some Exceptions to the Net Present Value Rule Anil Arya, John C. Fellingham and Jonathan C. Glover ABSTRACT: Textbooks tend to emphasize the net present value (NPV) rule, often arguing that it is theoretically superior to other methods. Yet other meth- ods, many of which do not involve discounting, are also used in practice. Hence, one of two conclusions can be drawn: (1) firms are making suboptimal deci- sions or (2) the assumptions underlying the NPV rule are not always met in practice. The purpose of this paper is to present simple numerical examples wherein applying the NPV rule leads to erroneous decisions. The examples highlight the assumptions underlying the NPV rule. INTRODUCTION C apital budgeting is a vital ac- tivity. It is the process by which organizations make long-term investment decisions. Textbooks in accounting and fi- nance discuss numerous evaluation criteria, including payback period, accounting rate of return, internal rate of return, and Net Present Value (NPV).i These criteria can lead to differing conclusions. The NPV rule of "accepting a project if and only if its NPV is posi- tive" is based on the intuitive premise that money today is worth more than the same amount of money in the fu- ture. Textbooks tend to emphasize the NPV rule, often arguing that it is theoretically superior to other meth- ods (see, for example, Kaplan and Atkinson 1989, 474-475; Zimmerman 1995,119). Yet other methods, many of which do not involve discounting, are also used in practice. For ex- ample, in a survey referred to in Horngren et al. (1997, 794), more firms reported using the payback method either as a primary or sec- ondary criterion to evaluate projects than any other method.^ Since companies use these other methods, one of two conclusions can be drawn: (1) firms are maMng sub- optimal decisions or (2) the assump- tions underlying the NPV rule are not ' See, for example, Horngren et al. (1997), Kaplan and Atkinson (1989), Ross et al. (1995) and Zimmerman (1995). 2 Another survey reported that the payback method is commonly used as a secondary cri- terion, but not as a primary criterion (see Ross etal. 1995,219). Anil Arya is an Associate Professor and John C. Fellingham is a Professor at Ohio State University and Jonathan C. Glover is an Associate Professor at Carnegie Mellon University. We thank Doug Schroeder, Li Zhang, stu- dents at Carnegie Mellon University and Ohio State University, Wanda Wallace (the editor), and two anonymous refer- ees for helpful comments. Anil Arya ac- Young. John Fellingham acknowledges support from theH. P. Wolfe Foundation.
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500 Issues in Accounting Education always met in practice. The purpose of this paper is to present numerical examples wherein applying the NPV nale leads to erroneous decisions. The examples highlight the assumptions underlying the NPV rule. Although the simplest version of
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Capital Budgeting Exception to NPV - Issues in Accounting...

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