Ross, S.A. (1995). Uses, abuses, and alternatives to the net-present-value rule. Financial Management, 24(3), 96-102
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Double Loop Learning in organizations was introduced by Chris Argyris in 1977. This article explains the hidden failure of error correction strategies in organizations and introduces a new organizational learning paradigm which can help assess and question the underlying assumptions of the daily and long-term decision making and problem-solving processes.
The article outlines the differences between Single Loop Learning (Model 1) and Double Loop Learning (Model 2). The Single Loop Learning model is very direct and straightforward in the error assessment and rectification. This model only reacts to variables that are relevant to the short-term operation of the organization. The second model is an evolution of the Model 1. It extends upon Single Loop Learning by analysing what the roots in which the decision making is based on are. It encourages to question the organization’s guiding principles.
The article highlights that companies are often successful in daily error detection but avoid questioning the mental model behind decisions. In addition, employees fear retribution for questioning the underlying motives of the decision-making process. The solution developed by the author, is to create a culture that encourages the questioning of mental models by implementing Double Loop Learning.
To solve the problems raised in the article, an open criticism and questioning culture should be encouraged. It is crucial that the employees are also taught how to criticise precisely. Secondly, the questioning culture must embrace the basis of the mental model in place so that it is possible not only to understand but also to improve it. Finally, the model implementation must start at the highest ranked managers and trickle down to the employees because they must lead from the forefront.
However, the model also has a few limitations. The article only mentions straight forward situations in which there is an obvious correct decision based on the perceived information. This is not always the case. One of the key limitations is that the gathered information can cause different decisions based on the decision maker. For these situations, guiding principles are useful.
Apart from that, rapidly changing mental models can be detrimental to a business’ success. They can derail long-term planning. Furthermore, customers might be scared off if they cannot assess the values which the company stands for. A company that has pledged adherence to green initiatives should not start making decisions that counteract their vision statement. The customer base which has likely been drawn in because of the company’s guiding principles would disapprove and dissolve.
Another important limitation are cultural aspects. Countries with other traditions often have different mental models. Criticism on these decision parameters can come off ill-willed.
However, the most important aspect is speed. Questioning guiding principles should always be encouraged but in situations where quick decisions are essential, it is useful to have a guiding principle that the decision maker follows.
Further readings:
(Video) R. Yapp – Double-loop learning: a case study from the front-line – TEDxWandsworth (2016)
(Article) Boal, K.B. and Schultz, P.L., 2007. Storytelling, time, and evolution: The role of strategic leadership in complex adaptive systems. The Leadership Quarterly, 18(4), pp.411-428.
(Article) Dong, J., Liu, R., Qiu, Y. and Crossan, M., 2020. Should knowledge be distorted? Managers’ knowledge distortion strategies and organizational learning in different environments. The Leadership Quarterly, p.101477.
(Article) F. Gino, 2019. Cracking the Code of Sustained Collaboration. Harvard Business Review
(Article) Jacob, W.F., & Kwak, Y.H. (2003). In search of innovative techniques to evaluate pharmaceutical R&D projects. Technovation, 23(4), 291-296.
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Key points
This paper describes the recent changes in the health care economy but also the scientific and technological revolution and their impact on the pharmaceutical industry. Then it examines a new way to evaluate pharmaceutical R&D projects.
In fact, the pharmaceutical industry has been using project management techniques for some time, but it didn’t work as well as in other industries. This is in large part because the development of new technology is very unpredictable in that sector and that makes the management of R&D projects difficult. It results in an increasing cost pressure and that forces pharmaceutical companies to find new way to evaluate R&D projects as soon as possible. And therefore, avoid huge cost and become more competitive.
At the same time, arrives the revolution of molecular genetics in science and technology. The exploitation of this new knowledge requires much larger R&D programs. To evaluate theses R&D project effectively, firms need to develop effective management tools.
The new way to evaluate pharmaceutical R&D projects that the article describe is the Real options analysis. The “option” word comes from the fact that it has great, but unknown, upside potential, with downside potential limited to the amount invested in the project.
Implications
Implications 21st century companies are now facing a new competitive landscape that involves many challenges but also and above all many opportunities. Good project management is therefore the key to developing a competitive advantage in this new highly competitive environment. It has now become as crucial to select the right projects, manage your company’s projects portfolio and optimize the allocation of resources as it is to manage an individual project. It is therefore through effective technology management that today’s managers will be able to meet these new challenges. The article proposes to managers to use the “real options analysis” tools to evaluate pharmaceutical R&D projects and replace the old tools, which are too theoretical or too difficult to put into practice. However, make the choice to invest or not in a R&D project by assessing the possibility of making a profit while limiting the risk of loss is a very complex exercise in the pharmaceutical industry. More practical decisions or actions can therefore be of great help for managers. First of all, managers must pay attention to the type, reliability and quality of information available about the specific project. It is the basis for the decision to continue the project and the allocation of resources accordingly. It is therefore necessary for them to adapt their assessment of the information to the situation as it evolves continuously as the project develops. The second decision that managers should make when using this tool is to focus on learning from the research team. Obviously, the development of new technologies constitutes new knowledge, but it must be directly or indirectly useful for the company, otherwise it is a waste of time and money. When examining a project, it should therefore be possible to evaluate what can potentially be learned, or after the end of the project, what has been learned. The last action to be taken in order to evaluate a project properly would be to choose the right people, both the right number of people and those who are experts in the field. The challenge here is to gain enough experience, whether in the field of management or science, as well as to develop a method that enjoys broad commitment and solid support for the further development of the project.
Limitations
First, the quality of information and the evaluation of information by the manager during the different phases of a project seems to be key points in order to allocate project resources and to decide whether a project should continue or not. However, this concept could not be applied in some companies in which managers focus too much on theory and prefer to evaluate their project only with valuation methods such as net present value (NPV) and discounted cash flow (DCF) without continuously reviewing the project and taking new informations into account. Moreover, when they are reassessing a project throughout its evolution, the managers will have to be careful to find the right sources of information, which means finding the right contacts. Finding good contacts can be complicated for different reasons such as a lack of expertise within the company, a contact network that could be too small or the fear of disclosing an R&D project. These elements could prevent managers from having enough information to better manage their project.
Secondly, the second implication emphasized that the manager should focus on learning of the research team by evaluating what has been learned at the end of a project. The limit of this implication is that developing new technology in the pharmaceutical sector is equivalent to acquiring new knowledge, but knowledge is not quantifiable precisely. There is no metric to evaluate what a project has really brought to the research team in terms of learning.
Finally, the third implication suggests that managers have to choose the right people to evaluate a project correctly. These people could be outside experts, representatives from several levels of management, as well as peers from other project teams. The limitation here is that this managerial implication will not be applicable in all types of companies. Large companies have the financial means to pay outside experts and they have enough management levels to bring together several representatives to evaluate a project. However, if we consider smaller companies and start-ups this is not especially the case. Their financial and human resources are often more limited. They don’t always have the possibility to find enough and the right people.
Further references
– Johnathan, M. (2016). Real Options Analysis (Third Edition): Tools and Techniques for Valuing Strategic Investments and Decisions with Integrated Risk Management and Advanced Quantitative Decision Analytics . USA :Kindle Edition
– Glantz, M., Mun, J. (2010). Real Options Analysis: Managing Risk Through Flexibility. Credit Engineering for Bankers. Chapter 12 Pages 295-308. USA: Academic Press.
– Eduardo A., Martinez C., Francisco R-D. (2013). Real options theory applied to electricity generation projects: A review Renewable and Sustainable Energy Reviews Volume 19, Pages 573-581.
Show lessKenney, H.S., & Pelley, B. (2014). Stories that drive the future: how narratives can improve scenario planning. Strategy & Leadership, 42(5), 28-33.
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The paper by Kenney and Pelley (2019) assesses the relationship between the quality of scenario planning and the consideration of narratives. Narratives are thereby defined as stories, images and anecdotes that articulate deeply-rooted human beliefs, attitudes and perceptions.
Key insights that the paper provides are that (1) traditional scenario planning often fails to adequately picture realistic future scenarios. The main reason for that is that managers rather only concentrate on identifying major technological, economic or political trends that they believe will shape the future of their business importantly. Thereby they fail to consider that (2) the development and spread of these trends is dependent on the reactions of society, rooted in people’s beliefs or perceptions. (3) Therefore, it is very important to integrate people’s beliefs, attitudes and perceptions into scenario planning. As these aspects often get visible in the form of narratives, scenario planning can be improved when narratives are taken into account.
These insights imply that managers should consider narratives during scenario planning. In order to identify the most important narratives, the following steps should be followed:
(1) Managers should explore a wide range of knowledgeable sources to identify the major themes which could represent potential narratives. To do so, they should read and scan a lot of traditional media and sample pop culture by exploring TV, documentaries, movies, novels etc.
(2) Managers should try to determine which stories motivate behavior. To be more effective, managers should care about the diversity of people within the team because they will have different perspectives in reviewing the research material. After a lot of team discussion were stories can emerge, they should weed through those to find the ones that appear to encapsulate deeply held beliefs and assumptions
(3) The last step is to discern the key narratives within the list they wrote, managers should identify the stories that actually govern behaviors and actions. To do so, they should ask themselves if the narratives satisfy these 3 criteria: 1. They are big ideas that stretch across issues and groups; 2. They are often rooted in issues of identity and culture; 3. They are often slow to change.
One limitation of these implications is that a diverse team is needed to identify and assess potential narratives. There exist several scenarios where the creation of a diverse team might be impossible. First, when the people inside the firm are too homogenous like it is frequently the case in small startups. Entrepreneurs often decide to work with people that are close to their environment and that therefore have similar perspectives and opinions. Second, managers might just not be able to identify diverse people within their team. This could be due to ignorance or a lack of experience. As a consequence, managers might choose a team that is not taking enough different perspectives into account due to too little diversity. Important narratives could then be overlooked.
A second limitation concerns the assumption that narratives could give a clear indication of how people would behave. This only holds as long as people’s beliefs and attitudes are similar to each other, as just in these cases strong narratives can be identified. For topics where beliefs are too diverse, narratives would be very fragmented as well. As a consequence, the identification of key narratives would be difficult and only weak implications for scenario planning could be derived. In such cases, narratives would not help to improve scenario planning. Possible reasons for the diversity of beliefs could be internet socialization and migration.
Further references
• Foster, W. M., Coraiola, D. M., Suddaby, R., Kroezen, J., & Chandler, D. (2017). The strategic use of historical narratives: A theoretical framework. Business History, 59(8), 1176-1200.
• Solouki, Z. (2017). The road not taken: Narratives of action and organizational change. Journal of Organizational Change Management, 30(3), 334-343.
Denning, S. (2006). Effective storytelling: strategic business narrative techniques. Strategy & Leadership, 34(1), 42–48
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ADANT Aurore, CALCUS Sophie, CLOQUET Nelson, VANDEN HERREWEGEN Géraldine, VIDREQUIN Charles.
This executive summary provides concrete insights for managers on how to make effective use of storytelling to achieve business purposes. Storytelling is the art of telling a story for communication purposes. More and more firms find it central to address many of today’s key leadership challenges, like enunciating risks and opportunities. But the main question is: “How to make effective use of storytelling?”
The first key insight this article provides to managers is to underline that there is not only one right way to tell a story. Indeed, there are 8 different narrative patterns applicable to different situations and it is crucial to be able to identify them for an effective use of storytelling. Those patterns depend on the objective that is pursued: sparking action; communication who you are; transmitting values; branding; fostering collaboration; taming the grapevine; sharing knowledge; leading people into the future. Each objective goes hand in hand with a distinctive storytelling strategy. Next, while storytelling can become an effective management tool for achieving business purposes if used properly, it is not to be forgotten that it is only a mean and not an end. Finally, managers should keep in mind the importance of positive tonality during storytelling to generate action and reaction of the listening people.
Even though, storytelling is not a natural gift every manager masters, it can be developed by practicing. That implicates that to improve and develop manager’s storytelling skills, companies could organize activities such as coaching, seminars, training, etc. to learn from experts. It is also important to remind managers to take their time to write down their speech. Once they have a good base, they should rehearse to master the story. Once comfortable with their text and that when used to narrate it, it will be more attractive for the. Another implication for managers is that they should not only focus on improving their storytelling skills because it is only a mean and not an end. Therefore, developing their human resources skills, their organizational skills remains essential too.
However, managers have to be aware that storytelling also has its limitations. First, telling stories with a positive tonality can hide critical truths in practical situations. Hence, we must be vigilant about narrative fallacy. It could happen that managers design a false narrative to make themselves feel better. Second, there is very little empirical evidence assessing the impact on the consumer’s responses of storytelling. Consequently, managers should not be too optimistic regarding the effect of introducing storytelling as there are no studies showing which kind of story works and when. Moreover, too much focus on storytelling could irritate consumers.
Further references:
Bartel, C. A., & Garud, R. (2009). The role of narratives in sustaining organizational innovation. Organization Science, 20(1), 107–117
Maclean, M., Harvey, C., & Chia, R. (2012). Sensemaking, storytelling and the legitimization of elite business careers. Human Relations, 65(1), 17–40.
Show less(Article) Cassar, G. (2010). Are individuals entering self‐employment overly optimistic? An empirical test of plans and projections on nascent entrepreneur expectations. Strategic Management Journal, 31(8), 822-840.
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Executive summary: Are individuals entering self‐employment overly optimistic? An empirical test of plans and projections on nascent entrepreneur expectations.
– Key insights (“What?”):
1) NASCENT ENTREPRENEURS ARE OVEROPTIMISTIC
The article explains that nascent entrepreneurs tend to be overly optimistic in their expectations about their business. In fact, according to the article, entrepreneurs tend to overestimate the probability that their activity would result in an operating venture.
That lead us to the concept of the inside view. Which is also called the “planning fallacy”. This concept tries to explain why an entrepreneur is positive or negative while making a forecast.
2) HOW THE INSIDE VIEW AFFECTS EXPECTATIONS IN AN OVERLY OPTIMISTIC WAY
When an entrepreneur adopts an inside view, he will make forecasts based on specific details of the case, obstacles to the project’s completion and by constructing scenarios of future progress. The expectations are influenced by the specifications of the situation rather than on the outcomes of similar cases or “base rate” information.
The high uncertainty of the forecasting task increases the risk of a greater cognitive bias. This situation of high uncertainty is particularly present in the entrepreneurial world.
3) STRONGER OVER OPTIMISTIC VIEW IN THE AREA OF NEW TECHNOLOGIES
The third point raised by the article is that it is more complicated for entrepreneurs in the technological area to stay rational in their expectations because all is new. The technological sector moves fast implying a greater uncertainty than in other sectors.
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– Managerial Implications (“So What?”):
1) OUTSIDE VIEW (using experience from previous similar ventures already completed)
Due to his/her inside view, the entrepreneur is more confident in his/her expectations of the future outcomes of the project than what eventually occurs. Entrepreneurs perceive the tasks to achieve as controllable, which exacerbates their overoptimism.
Therefore, to mitigate that risk, decision makers should take more outside sources of information into consideration. In addition, they should keep track of the abilities and potential actions of competitors.
2) OPTIMISM IS GOOD
Still, we take here the risk to come up with an inconclusive , half-and-half point but we think optimism is something important to have for businesses. Some can argue that it is better to have a positive leader that might commit mistakes than one that is always right. It gives dynamism to the business and might also boost the willingness of the company to innovate.
3) THE PSYCHOLOGICAL IMPACT OF THE OPTIMISM OF BUSINESS LEADERS
Even if entrepreneurs are wrong in their expectations, an overly optimistic view can generate positive externalities. For example, an optimistic business leader will motivates more easily his team or convince investors to put money in their project. We saw that the general business climate can condition the future. Let’s be concrete, if people are afraid by an oil shortage, they will quickly buy most of the gazoline and effectively create an oil shortage. This influence might also happen in the business world. If an entrepreneur is optimistic, his company will be perceived in an optimistic way and that could lead to positive externalities.
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– Limitations:
1) THE SAMPLE IS LIMITED TO THE UNITED STATES
The sample used in this article contains only people from the US mainland. Their overconfidence may come from the American culture in which the American dream still occupies an important place. This study does not consider the fact that, on other continents, the behavior and self-confidence of individuals is fundamentally different from those of Americans partly due to their different culture. The socio-cultural context is not taken into account in this study, although it probably has a significant impact on the results it presents.
2) RELATING ON PAST EXPERIENCE TO REDUCE THE EXPECTATION BIAS
As seen in the implication part, one way of reducing the expectation bias due to managerial practices is to relate to past experience. This solution is not applicable in the case of a totally new product which would be launched on a new market because experience in that specific area just doesn’t exist.
3) THE INTEGRATION OF THE EMOTIONAL ASPECT
The article explains where this exacerbated optimism comes from. However, it does not deeply cover the emotional aspect of this overconfidence, and being aware of the cognitive mechanisms behind it could be helpful in emotion regulation. If nascent entrepreneurs are aware of the influence of their emotions on decision-making processes, and have tricks to regulate it, it will be easier for them to have more objective expectations. We have found some answers to this issue thanks to an article we used in our further readings.
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– Further references:
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1) Flyvbjerg, B. (2013). Quality control and due diligence in project management: Getting decisions right by taking the outside view. International Journal of Project Management, 31(5), 760-774.
This paper highlights the difficulty to estimate ex post realizations when analyzing the ex ante expectations. It goes even further by describing what quality control is in the context of project management, and demonstrate it with a real-life project. In one word, the paper learns how to de-biase project management.
2) Im, M., & Oh, J. (2016). Effect of emotion regulation as a de-biasing mechanism on overconfidence in investment behavior. Journal of Financial Services Marketing, 21(3), 209-225.
This one states that people who are able to regulate their emotions, and especially the strong positive ones such as pride, will be able to reduce bias concerning the future of business.
3) Trevelyan, R. (2008). Optimism, overconfidence and entrepreneurial activity. Management Decision, 46(7), 986-1001.
This article distincts confidence in two different dimensions by making a distinction between optimism and overconfidence.
BONUS) Lovallo, D., & Kahneman, D. (2003). Delusions of success. Harvard business review, 81(7), 56-63.
We decided to propose a “bonus article” as it was too old to be considered as further reference. We still think it is a very interesting article as it has inspired most of the previous works.
Courtney, Hugh. “Decision-driven scenarios for assessing four levels of uncertainty.” Strategy & Leadership 31.1 (2003): 14-22.
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Key insights :
The article underlines the way scenario planning can be used while taking into account the risks and the potential uncertainties in a decision-driven way. To build your decision-driven scenarios you have to know on which level of uncertainty you are. The article has classified uncertainty among 4 different levels. Level 1: A clear enough future: the future is predictable enough to identify a dominant strategy choice that is best across the range of potential outcome. It’s better for companies to do sensitivity analysis as they can collect data. Example : Location of a new Mcdonald’s restaurant. Level 2: Alternate futures: decision-makers face Level 2 uncertainty when they can define a limited set of possible future outcomes which are MECE (mutually exclusive, collectively exhaustive) and when only one of which will occur. Example : The future president of America. Level 3: A range of futures: decisions makers can only bound the range of future outcomes, they cannot identify a limited MECE set of outcomes.This level is often faced by companies when they try to identify the demand for a new product or service they will launch. Level 4: True ambiguity: futures outcomes are unknown and unknowable, companies and managers can’t even find a range of possible futures outcomes of possible scenarios. What the managers should do is to work backwards. The scenarios here are a set of assumptions that are credible regarding analogous situation that you faced in the past. Example : Brexit.
Implications :
The implications depend on which level of uncertainty the company faces.
– Level 1: Simulation and sensitivity analysis are great provided that you already have data. The idea to directly launch a prototype instead of waiting for the perfect final product allow the company to collect new information, observe, analyze and then improve the project with accuracy. Example : Mcdonald’s decided to test a restaurant prototype in Hong-Kong.
– Levels 2&3 : Gathering a set of experts will help you to identify the scenarios which are more difficult to predict and are not in your field of business. In those levels, it is essential to be proactive. Example : Besix has a partnership with a legal firm to help with juridical issues that may happen.
– Level 4 : Managers and employees should be reactive, react quickly to change, create new decision trees and range of scenarios. Example : The 9/11 terrorist attack pushed the airports to be more cautious about security in order to prevent potential future attacks.
Limitations :
– This way of integrating uncertainties is mainly focus on the short-term and doesn’t mention any long-term vision which is also important to identify and to link with the short-term strategy.
– It can be expensive to gather a team of experts and difficult to find the right experts for the right issues.
Further references:
-Marren, P. B., & Kennedy Jr, P. J., (2010), Scenario planning for economic recovery: short‐term decision making in a recession, Strategy & Leadership, Vol. 38 Issue: 1, pp.11-16. Online : https://www.emeraldinsight.com/doi/pdfplus/10.1108/10878571011009831
→ Scenario planning can be used to make short term economic decisions.
-Meissner, P., & Wulf, T., (2013), Cognitive benefits of scenario planning: Its impact on biases and decision quality, Technological Forecasting & Social Change. Online : https://ac.els-cdn.com/S0040162512002375/1-s2.0-S0040162512002375-main.pdf?_tid=8a1eda27-008d-4480-ac6b-2d543c0b4b56&acdnat=1544169735_2520a03287e94062fdb95612d8dd2023,
→ Analyzes the effect of scenario planning in decision making as well as on decision quality.
-(video) Shell, Navigating an Uncertain Future. Online : https://www.youtube.com/watch?v=nwub4Bhr-aM.
→ Shell explains how they use scenario and face the future uncertainties.
Ghosal, Vivek, and Prakash Loungani. “The differential impact of uncertainty on investment in small and large businesses
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Authors of the paper are trying to prove, with empirical analysis, how investments respond to changes in uncertainty about profits and whether or not this response is different in industries that are dominated by small firms against those dominated by relatively larger firms. Small firms are defined as firms which have a maximum of 100 employees, and big ones are firms with more than 100 working people.
Regarding the key insights of our paper, we first need to explain what are the 4 hypotheses made in order to confirm the final results.
1 The firm size is used as a proxy for capital market access to test empirically the fact that the impact of profit uncertainty on investment may differ across firms. Indeed, some firms could not fund on outside bank borrowing or external equity.
2 Sunk costs (that refers to costs that have already been incurred and cannot be recovered) can be seen as a barrier-to-entry. The fact is that markets with few large firms are more likely to integrate firm with higher sunk costs. According to that, industries dominated by small firms integrate firms with less sunk costs.
3 About risk preferences, the authors of the paper are not aware of any work to demonstrate that attitudes vary by firm size. The only valuable indication in the theory is that under uncertainty, firms with greater risk aversion will tend to have lower outputs and inputs.
As a conclusion of this text, there are two key findings. Firstly, it appears that the sign of the relationship between investment and uncertainty is negative. Secondly, the negative impact of uncertainty is greater in the small firm industry than in large firm industry.
For the situations explained in the paper we found two possible managerial implications. The first implication is that, in order to integrate risks and address uncertainties, the company can make sensitivity analysis and build scenarios. It will help them have more information about the risks and uncertainties and therefore better cope with their potential impact. The second implication is for industries dominated by small firms. In these industries, there is no sunk cost barrier. Therefore, small firms should find other barriers to prevent large firms from entering their market. An example would be intellectual knowledge.
Finally, we can highlight three limitations of this paper. The first one is that it doesn’t totally apply to Start-ups. Indeed, a Start-up must make investments in order to grow-up and develop its business even in a context of higher uncertainty about profit. The second limitation is that, sometimes, you can receive a risk premium for not staying in a risk-free environment and, so higher uncertainty can lead to a higher risk premium. And that higher premium can be an incentive to invest. The last limitation is that some industries require firms to keep taking risks and making investments even if uncertainty about the future profits of these investments increases. We can think about the high-tech industry or pharmaceutical industry.
To get wider picture about the topic, further references are suggested below:
• Leahy, John, and Toni Whited, “The Effect of Uncertainty on Investment: Some Stylized Facts,” Journal of Money Credit and Banking 28 (1996), 64-83.
• Dixit, Avinash, and Robert Pindyck, Investment Under Uncertainty (Princeton: Princeton University Press, 1994).
Ross, S.A. (1995). Uses, abuses, and alternatives to the net-present-value rule. Financial Management, 24(3), 96-102
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The Net Present Value (NPV) Method was generalized by the statistician Fisher at the beginning of the 20th century. This theory was created to evaluate a potential value which could be gained by an investment.
At first, this paper examines the problems concerning the usage of the NPV theory. The standard NPV Theory which is taught during the introductory finance course at university, oversimplifies assumptions to present a method with reduced complexity for a simple application in the context of investment valuation. The author proposes to revisit the ways to make investment decisions. He opposes the statement that an investment should be undertaken if it has a positive NPV. The author further argues that, as a rule of thumb, all investment decisions must be treated as an option pricing problem in order to have a practical and salutary impact on the decision process of an investment.
He develops the understanding, that the value of optionality can be attributed to two main implications. The first implication is that the consideration of the bounded capital is essential. This means, that an investment in one project with a small positive NPV binds the investment capital and therefore cannot be invested in a possible later investment with an even higher NPV. This relationship relates to the lost opportunity cost. The second implication is that a project with a negative NPV does not imply that the project has no value. The original NPV is based on the current interest rate, which is not fixed and can be subject to fluctuations. Possible influence factors of the interest rate can be stock market crashes, pandemics, or the recent low interest rate policy of the ECB. Therefore, a project which has a negative (or positive) NPV today can change its value over time due to these fluctuations. This can have huge influences on the investment decision if it is based on the statement that the author criticises. This implies, that an investment project with a negative NPV always has a value of optionality, which is not reflected in its NPV.
In our understanding, this new method to evaluate the value of an investment has three major limitations. The first limitation is that the real value of the original NPV is an estimation which always includes uncertainty. This leads to the second limitation, that the accuracy of a project value forecast will not necessarily always increase by adding a new assumption. This limitation is based on the connection that more assumptions increase the complexity and thus the needed effort to invest to get a proper forecast. The third and last limitation is that the NPV is a method that is globally agreed upon to provide a solid estimation. With this commonly used method, most participants understand the correlations and results presented by this method Because change often creates resistance, introducing a new system or adding a new assumption is likely to unnecessarily disrupt a previously stable system.
Further readings
Show less(Book) M. Desai, 2019, How Finance Works: The HBR Guide to Thinking Smart about the Numbers – Harvard Business Review
(Article) B.M. Lambrecht, S.C. Myers, 2017, The Dynamics of Investment, Payout and Dept, Review of Financial Studies, Vol. 30, Issue 11, Pages 3759-3800
(Article) J. Woo, E. KIM , 2019, Developing an Improved Risk-Adjusted Net Present Value Technology Valuation for the Biopharmaceutical, Journal of Open Innovation: Technology, Market, and Complexity, SJR Scopus H-Index: 20