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Management article
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Reference no. 95303
Published by: Harvard Business Publishing
Published in: "Harvard Business Review", 1995

Abstract

Companies make capital investments to create and exploit profit opportunities. Opportunities are options - rights but not obligations to take some future action. The old net present value presumption that investment decisions are either reversible or now-or-never propositions turns out to be flawed. Irreversibility, uncertainty, and the choice of timing alter the investment decision in critical ways. Investment expenditures are irreversible when they are specific to a company or to an industry. The simple NPV rule should be modified: Instead of being merely positive, the present value of the expected stream of cash from a project must exceed the cost of the project by an amount equal to the value of keeping the investment option alive. Because they create and preserve options, decisions such as those to test a market or conduct R&D enhance a company's flexibility and should be made more readily than a naive NPV would suggest; but decisions that reduce flexibility should be made more hesitantly and be subjected to stiffer hurdle rates than the cost of capital.

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Abstract

Companies make capital investments to create and exploit profit opportunities. Opportunities are options - rights but not obligations to take some future action. The old net present value presumption that investment decisions are either reversible or now-or-never propositions turns out to be flawed. Irreversibility, uncertainty, and the choice of timing alter the investment decision in critical ways. Investment expenditures are irreversible when they are specific to a company or to an industry. The simple NPV rule should be modified: Instead of being merely positive, the present value of the expected stream of cash from a project must exceed the cost of the project by an amount equal to the value of keeping the investment option alive. Because they create and preserve options, decisions such as those to test a market or conduct R&D enhance a company's flexibility and should be made more readily than a naive NPV would suggest; but decisions that reduce flexibility should be made more hesitantly and be subjected to stiffer hurdle rates than the cost of capital.

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