Friday, August 17, 2007

Evaluating Investments: Theory and Practice

Let’s say you or your company is deciding whether to make some sort of new investment. How do you go about deciding whether it makes sense? The typical advice from economics / finance professors is to perform some sort of net present value (NPV) analysis. Project all of the proposed cash flows from the project, properly discount future cash flows to reflect the fact that a dollar received in the future is worth less than a dollar received today, and calculate the net. If the NPV is positive, you’ve got yourself a good investment. Live long and prosper.

Despite the masses of MBAs bludgeoned with the importance of NPV analysis over the years, other techniques remain in practice. In a very interesting paper that appeared in the Journal of Financial Economics, two Duke professors examined how real CFOs make decisions and found that over half of surveyed CFOs used the payback period as a technique to evaluate projects. Interesting because, as any first year MBA who has completed core Finance can tell you, the payback period technique can lead to incorrect decisions.

Theory sure is nice, but practice is often very different.

[I should add a few caveats related to NPV analysis. First, it’s not entirely clear what discount rate you should use – the standard story from finance is to use your weighted average cost of capital, but not everyone agrees on how this should be calculated. Second, real options theory would argue that simple NPV analysis misses some critical values flowing from the option nature of projects.]

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