How should a firm and its management evidence its decision to invest in a company, in new equipment, in new projects, in new markets? Most of us have learned at some point in our education that such a decision should be based on financial analysis, looking at the payback period, at the internal rate of return or better, at the Net Present Value of the project. We have been taught that we should invest if the Net Present Value (NPV) of the project is positive. Yet many readers will agree with me that in “real life”, projects with a “high” internal rate of return happen to be postponed and that for “strategic reasons”, projects happen to be undertaken when their NPV is negative. And, after all, sometimes these decisions appear to have been the good ones…
So, are the decision tools we were provided with the right ones? Are we missing something? Should we forget NPV to assess our investments and rely on “strategy”, “vision” and “business flair” only?
No ! Tools such as NPV were developed at a time when technology and market developments were evolving at a slower pace than at the beginning of the 21st century, at a time when uncertainties about future prices, sales volumes and regulations were lower than today. These tools have been useful and remain useful in many situations. In some circumstances, however, their use can lead to inappropriate decisions. The key issue for management is to identify when this might happen and in these cases to use better, more appropriate tools.
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