Net Present Value, Duration, and CAPM in Light of Investment Theory: A Comment on Kruk
Abstract: In her paper “Corporate Risk Evaluation in the Context of Austrian Business Cycle Theory” recently published in this journal, Joanna Kruk aims to investigate how artificially low interest rates resulting from central bank intervention distort individual investment appraisals and ultimately result in both entrepreneurial misjudgment and resource-wasting malinvestment, fueling the business cycle. She identifies entrepreneurs’ net present value calculations, supposedly unadjusted for risk, as a major issue and suggests adjusting those calculations for risk via both the duration method and the Capital Asset Pricing Model to mitigate the distorting effects. Her argumentation is, however, trapped in neoclassical reasoning and is adversely affected by several misconceptions of the net present value criterion. This comment seeks to reveal those fallacies and explain how to address uncertainty when using net present value calculations to make those calculations part of the solution rather than part of the problem of entrepreneurial misjudgment. The findings are derived from German investment theory rooted in the Austrian school of thought, meaning that they differ compared to those of neoclassical finance theory.
JEL Classification: B31, B41, B53, G32
Thomas Hering ([email protected]) is a professor of business economics and holds the Chair of Investment Theory and Business Valuation at Fern-University in Hagen, Germany. Michael Olbrich ([email protected]) is a professor of business economics and chair of the Institute of Auditing at Saarland University, Saarbrücken, Germany. David J. Rapp ([email protected]) is an associate professor of accounting and management control at Institut Mines-Télécom Business School and member of the research lab LITEM, Univ. Paris-Saclay, Univ. Evry, IMT-BS, Evry/Paris, France.
In her paper “Corporate Risk Evaluation in the Context of Austrian Business Cycle Theory” recently published in this journal, Kruk (2020) seeks to explain why and how artificially low interest rates brought about by central bank intervention distort individual investment appraisals and eventually lead to clustered entrepreneurial misjudgment, malinvestment, and capital consumption, that is, the business cycle. Her perception of previous research is that “little attention was paid to the analysis of corporate finance and the causes of companies’ erroneous decisions about initiating and carrying out unprofitable undertakings,” which indicates she believes that investigating “the motivation of financial decisions on a micro-level can shed new light on the foundations of the emergence of the business cycle” (Kruk 2020, 131–32). Certainly economic calculation in general, and entrepreneurial investment decisions in particular, are yet to be thoroughly explored from the perspective of the acting individual and those areas should be stringently investigated owing to their significance for both Austrian theorizing (e.g., Austrian business cycle theory [ABCT]) and practice. However, there has already been far more discussion on the topic than Kruk (2020) suggests, both in general terms and with explicit links to ABCT.1
In essence, Kruk (2020) asserts that the economy shifts toward a riskier position in response to artificially low interest rates and that decision-makers fail to incorporate that risk appropriately in their investment calculi. By neglecting investment risk, entrepreneurs invest in projects that are only seemingly profitable. To aid in mitigating this issue, Kruk suggests adjusting net present value (NPV) calculations, which serve as the basis of investment decisions, for risk. Kruk’s underlying idea is to decrease resulting NPVs by applying mathematical adjustments to make investment projects look less feasible in order to deter entrepreneurs from making poor investments. Specifically, Kruk suggests NPVs risk-adjusted based on both duration and the Capital Asset Pricing Model (CAPM).
However, entrepreneurs calculating an NPV must consider their individual circumstances if they are to receive a figure that is realistically supportive of the decision-making process, and naturally, this includes the consideration of what Kruk labels risk. Mises (1952, 126, italics added) explains:
One of the items of a bill of costs is the establishment of the difference between the price paid for the acquisition of what is commonly called durable production equipment and its present value. This present value is the money equivalent of the contribution this equipment will make to future earnings. There is no certainty about the future state of the market and about the height of these earnings. They can only be determined by a speculative anticipation on the part of the entrepreneur.
Contrary to Kruk’s reasoning, neither duration nor CAPM serves to support entrepreneurs’ speculative decision-making well. This comment aims to uncover the misconceptions inherent in Kruk’s argument and to present alternative ways of addressing uncertainty when using the NPV as a tool to support entrepreneurial decision-making. To do so, we build on Prussian-German business economics, especially investment theo
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