well-documented limitations. First, if a project’s cash flows switch between positive and negative more than once, the IRR calculation can yield multiple mathematical solutions, providing no single rate on which to base a decision. Second, even when unique, IRR ranks investments by relative percentage return rather than absolute value creation, which can make smaller projects appear preferable to larger ones that generate far greater net benefits. NPV avoids these issues by offering a single, unambiguous measure of value added. The NPV formula has become an integral component in modern finance and is embedded in the investment decision-making process. It provides a model for evaluating positive value creation (positive NPV) or value destruction (negative NPV), focusing predominantly on financial aspects of investments (i.e., cashflows) within a defined timeframe. However, non-financial outcomes, including externality risks are rarely considered or quantified and the manifestation of these externalities can lead to macro-economic shocks or the attritional destruction of the initial value creation. Given this, we suggest that conventional NPV calculations have often failed to accurately evaluate investments by not correctly capturing or pricing material positive and negative long-term outcomes, whilst disproportionately weighting the present over the future. In certain instances, long-term value destruction may cannibalise shorter-term value creation, however the existing NPV model often fails to capture this. In this paper we endeavour to unpack some of the limitations around NPV and r and outline an alternative approach that may offer practitioners a more holistic view. A material variable here is the exclusion and quantification of non-financial outcomes, both social and environmental. At the point of NPV’s inception, quantification of these variables was inconceivable. However, as we have become increasingly sophisticated in terms of finance, economics and science, quantifying these variables is now possible (see Appendix 1).
To support our argument, our analysis sets out three significant limitations of the NPV model:
• • •
Static discount rates.
Monological discounting. Intertemporal myopia.
Next, each limitation is discussed in turn.
Static Discount Rates
Our first limitation focuses on static discount rates.
The discount rate in financial analysis can take various forms, including the Weighted Average Cost of Capital (WACC) 19 , which incorporates the cost of equity using the Capital Asset Pricing Model (CAPM) 20 , the cost of debt, and the risk-free rate. It can also refer to the Required Rate of Return (RRR), which represents the minimum return an investor expects to justify the risk of an 19 The Weighted Average Cost of Capital represents a company's average cost of financing from both equity and debt sources, weighted by their respective proportions in the capital structure. For more, see: Hargrave, M. (2024). Weighted Average Cost of Capital (WACC): Definition and Formula. [online] Investopedia. Available at: https://www.investopedia.com/terms/w/wacc.asp. 20 The Capital Asset Pricing Model is a fundamental formula in finance used to estimate the cost of equity by quantifying the relationship between risk and expected return. For more, see: Kenton, W. (2024). Capital Asset Pricing Model (CAPM) and Assumptions Explained. [online] Investopedia. Available at: https://www.investopedia.com/terms/c/capm.asp.
5
Powered by FlippingBook