Economics Letters 84 (2004) 427 – 432 www.elsevier.com/locate/econbase Present value criterion: the case of differing borrowing and lending rates
Liqun Liu *, Andrew J. Rettenmaier, Thomas R. Saving
Private Enterprise Research Center, Texas A&M University, College Station, TX 77843-4231, USA Received 1 March 2004; accepted 9 March 2004
Available online 4 June 2004
Abstract This paper examines the present value criterion in a capital market with differing borrowing and lending rates. The more general present value criterion not only extends its applicability, but also enables us to better understand some features of the traditional present value criterion for a perfect capital market. D 2004 Elsevier B.V. All rights reserved.
In this paper, we explore further the properties of NPVN and NPVG to shed some light on the present value vs. rate of return debate, especially with respect to the NPV’s advantage of not having to resort to pair by pair comparisons in selecting from a mutually exclusive set and the anomaly of the NPV with respect to interest rate changes. Specifically, we first show that for two mutually exclusive N N G G N G projects x and y, it is possible for NPVx >NPVy and NPVx < NPVy but NPVx À y < 0 and NPVx À y > 0. Therefore, even using the present value criterion, choice among mutually exclusive projects requires pair-by-pair comparisons in a capital market characterized by differing borrowing and lending interest rates. Consequently, the primary advantage of the present value criterion over the rate of return criterion is then lost. We then show that the NPVN is non-increasing in the borrowing rate and nondecreasing in the lending rate. On the other hand, NPVG is non-decreasing in the borrowing rate and non-increasing in the lending rate. Thus, both NPVN and NPVG are