Two Flaws of the Net Present Value Criterion

Abstract

For project evaluation, the net present value (NPV) criterion is the most
preferred one. It attaches a pre-fixed opportunity cost to initial investment.
Therefore, it ranks projects by the amount of profit. It favors bigger size
projects. If supply of capital for a country is limited, then individual firms’
project selection by the NPV criterion may lead to less than potential level of
output, a flaw of this criterion. The other flaw is that its formula does not
account for the opportunity cost of initial investment if a project is to be
financed by owners’ capital. Consequently it overestimates NPV of such
projects.