Corporate Finance

The Net Present Value (NPV) approach is a project appraisal technique that uses the discounting of future cash flows at a given discounting rate at a particular time. It aims at determining whether an investor can obtain a particular yield given a specified initial outlay (Schmidt 2013). The NPV method is widely used in most organizations that undertake capital expenditure and rationing decisions. Due to limited resources, capital rationing has become an essential decision that managers must make. Thus, managers continue to be faced with restrictions on resource allocation. It will lead to long-term shareholder value maximization. The NPV method is a widely used technique of capital budgeting. The appraisal tool was firstly attributable to Fisher, who came up with the concept in 1930 (Shimko 2001). The project evaluation technique, however, suffers from a number of shortcomings. These shortfalls of the net present value approach are evident because it does not consider an effect of risk diversification on asset valuation. The other two project appraisal techniques that complement the NPV method include the Internal Rate of Return Method and the Discounted Payback Period Method. This paper discusses the theoretical rationale for the NPV method by assessing its principal strengths and weaknesses against those of other two commonly used methods. It further aims at disclosing applicability of various appraisal tools with respect to prevailing factors such as inflation, interest rates, and risk.

Capital Rationing and the NPV Technique

Capital rationing involves the evaluation of the firm’s investments and the optimal allocation of resources to various competing alternatives, according to their profitability. The NPV is a capital budgeting technique that aids the company’s management in allocating its limited resources to various competing alternatives (Borad 2012). These projects will need to be financed with a limited and strict budget. It results in capital budgeting in which the firm’s resources are optimally allocated to those projects that maximize the long-term shareholder value. The long-term implications of investment projects make capital rationing an essential business activity (Florida International University 2015). The investment decisions also involve a lot of risks. Thus, they require a careful analysis and approval by the top level management. The limitation on an access to resources results from the restriction of capital that may be imposed internally or externally. Companies can only undertake those projects that do not exceed their capital ceilings (Borad 2012). Capital rationing decisions are essential to the long-term growth of the enterprise rather than its short-term profitability (Capital Investment 2015).

The Rationale for the NPV Approach to Investment Appraisal

The Net Present Value technique involves the discounting of cash flows and deducting the present value of cash flows from the initial outlay (Capital Investment 2015). The company’s required rate of return is used as the discounting rate over the stated useful life of the project. There exists an inverse relationship between the net present value and the discounting rate. A high rate leads to a small NPV while a little discounting rate results in a very high value of NPV (Schmidt 2013). The NPV method of capital rationing evaluation, thus, aims at determining the present value of the project’s cash flow streams using an acceptable discounting rate.

The NPV approach is suitable when evaluating mutually exclusive projects. Only those projects with the highest positive NPVs are preferred to those with lower NPVs. Taking an example of four projects with NPV values of $20m, $15m, $2.5m, and -$0.5m respectively, it is very easy to determine the viable investment projects (Schmidt 2013). The investment opportunity that generates the NPV of $20m is the most profitable capital investment. It is feasible to invest in since the value of its discounted cash flows exceeds that of the project’s initial outlay cost by $20m. The next most feasible investment opportunity is such one, which generates the NPV of $15m, followed by the third project creating $2.5m. The project with the least NPV value of -$0.5 million is a loss-making project. Thus, it should be ignored (Schmidt 2013).

Positive NPVs indicate that the present value of project’s cash flows exceeds the initial outlay cost. The negative NPV value indicates that the current value of the initial outlay cost exceeds the current value of expected cash flows from the investment. The method gives a suitable criterion for accepting or rejecting the particular project based on the resulting NPV. The NPV rule may lead to misleading results since it does not take into account the interest rate sensitivity, the changes in inflation levels, and projects with unequal life terms. Despite these shortfalls, the NPV approach to investment appraisal measures accurately the profitability of the given project. The discounting of cash flows ensures that all cash flows that are generated over the project’s useful life are considered. The method also considers the risks involved in generating the cash flows by using the cost of capital as the discounting rate.

The Uses, Abuses, and Alternatives to the Net Present Value Rule

Borad (2012) proposes a four-step approach to capital rationing. The NPV is applied in the first step that involves the assessment of various investment proposals by considering their cash flows over the pre-determined useful life. The evaluation is then followed by ranking of projects on the basis of their NPV values starting with the project with the highest NPV value and concluding with the one of the least NPV value. The ranking is then followed by the selection of projects in the order of profitability until the company’s capital budget is exhausted. Those projects with negative NPV have the limited profitability. They are hence not viable. Given the simplicity of the process, the NPV method is widely used in most organizations to undertake a project appraisal. Despite its widespread acceptance, the NPV method faces significant limitations taking into account the risk factors.

The limitations of the NPV test arise from the risk-based valuation that the method applies. There exist a lot of risks in the financial markets. It results in the distinction between risk-bearing and cash-provision. In addition to this financial market risk, the NPV method does not take into account the effect of risk diversification as a result of asset investment. It means that only the risk averse and well-diversified investors can be infinitely capitalized and thus can be able to disregard diversifiable risks (Shimko 2001). The NPV technique does not take into account the investors’ risk-bearing capacity in the asset evaluation process. The NPV test states that projects with negative NPV values should be discarded (Ross 1995). The evaluation criterion also proposes that investors should only undertake projects with the positive NPVs. According to Ross (1995), the simple NPV rule creates a significant dilemma for investors.

The dilemma being created by the NPV criterion affects the nature of investment decisions that investors can make (Ross 1995). It arises because the assessment criterion places a caveat on an ability of a decision maker to accept or reject specific projects. The acceptance of the specific project can only be viable under the NPV rule if it does not affect the decision to undertake a different investment alternative. The dilemma leads to three scenarios in NPV-based capital rationing, i.e. the good, the bad, and the ugly. The good investment appraisal decision arises when the decision to reject the particular project is made when investment should have been rejected. The bad scenario occurs in project evaluation situations in which the investment is dismissed by investors when it should have been accepted (Ross 1995). Additionally, the ugly scenario arises in those circumstances in which an investment decision is made when it should have been rejected (Ross 1995). The three scenarios lead to significant limitations to the NPV rule thus making it unreliable for strategic decision making.

In order to illustrate the three situations, Ross (1995) evaluates the decision by a company to invest in the project costing $100 million. Given the high amounts of investment involved, the top level management will participate in approving the project. The returns on the project are expected to be very high. After the end of the first useful life of the project, the salvage value is expected to be $110 million. Given the discounting rate of 10.3%, the project’s NPV is determined as negative $300,000 (Ross 1995). The management has an opportunity of flipping the project at the price of $30000, raking in the profit of $20000. The project’s one-year interest rate decreases from 10.3% to 9.8% after successfully flipping the project. The decrease in interest rate levels leads to the NPV of $200000. The real estate developer takes over the investment worth $200000 in the NPV and makes $170000 in profits after just a month (Ross 1995).

The good scenario in the management case arises when the project’s investment decision becomes heavily dominated by the capital market alternatives. Given the interest rates of 10.3%, the project costing $100 million will earn the investors the return worth $110.3 million after a year (Ross 1995). The decision to invest in the project does not maximize the long-term shareholder value since there are better alternatives within the capital market. For this reason, the project should have been rejected and the management went ahead and undertook it at the negative NPV of $300000. The other limitation of NPV arises when any decision is made not to invest in the project when it should have been accepted. In the above management case, the company sold the project at the profit of $10000. The buyer who was a real estate developer goes ahead to rake in $170000 in profits, one month after the purchase (Ross 1995).

Investing in the project gives to owners some rights for the investment. Thus, the decision to disposal of the project amounted to rejecting it when it should have been continued. The reduction in interest rate levels will result in the positive NPV value. The final scenario in the management problem arises when there is a wrong application of the NPV rule. It results in accepting the project when the investment should have been rejected. The management is faced with the problem of undertaking projects as long as they have positive NPVs. The decision to undertake the investment does not take into consideration the caveat to the NPV rule. The decision to take the particular investment may interfere with the company’s ability to undertake an alternative project. Since the NPV technique is applied in capital rationing decisions, the decision to delay the particular project results in interest rate uncertainty. In the above management case, the management disposed of the project’s rights at a low price. By making the sales, the management has foregone the expected future benefits (Ross 1995).

Principal Strengths of the NPV Technique to Capital Budgeting

According to Peterson-Drake (2015), the NPV approach to investment appraisal is advantageous to investors since it takes into consideration all cash flows being generated by a project. It also takes into account the time value for money and highlights the increase in the firm’s value resulting from the project. In employing the cost of capital as the discounting rate, the NPV technique takes into account the risk of future cash flows of the particular investment. The decision to take a project is dependent on the value of the NPV. It thus gives to investors an opportunity to undertake a smart financial decision (Boundless.com 2014). Mackevičius and Tomaševič (2010) note that the concept of the NPV is widely used in the appraisal of investment alternatives using the projects’ discounted cash flows. In addition to this, the NPV technique has a strong methodological basis and a universal character (Mackevičius et al. 2010).

The principal strengths of the NPV approach to investment appraisal are also evident in its broad application in a financial investment analysis, a business value analysis, and an investment project evaluation (Mackevičius et al. 2010). Umanitoba (2003) argues that the NPV is an effective project assessment tool, being provided that its results are easier to be interpreted and understood. In addition to this, the acceptance criteria that are used for the NPV technique are consistent with a shareholder wealth maximization rule (Umanitoba 2003). The NPV approach is favored given that it is highly consistent compared to other project appraisal techniques (Nábrádi & Szôllôsi 2006).

The Shortfalls of the NPV Approach to Investment Appraisal

The NPV of a project is a discounted value of future cash flows, subtracted from the initial outlay cost (Ross et al. 2005). The approach is disadvantageous since it ignores the economic attractiveness for the initial capital outlay of particular projects. Helfert and Helfert (2001) point out to this limitation in which the NPV size is significantly affected by the size of the initial outlay cost. The method also fails to incorporate the discounting principle and the required rate of return on the firm’s capital. The situation makes it difficult for investors such as farmers who have an idea of return on capital but lack knowledge of NPV implications (Samuel Roberts Noble Foundation 2007). It also fails to provide an exact measure of the project’s exact rate of return (Csub 2015). The importance of providing an accurate measure of the required rate of return is emphasized by (Arnold 2012; Berk 2010).

NPV versus the IRR

The Internal Rate of Return technique considers the yield on investment or the marginal efficiency of capital in determining the investment viability of the given project (Brealey, Myers & Allen 2008). The IRR is superior to the NPV since it incorporates the discounting principle and the required rate of return on the appraisal of firm’s projects. Hillier (2010) highlights the significant limitations of the NPV rule. The IRR is, however, disadvantageous since it fails to provide a distinction between borrowing and investing. The existence of multiple IRRs or the non-existence of a single IRR may also cause problems to decision makers (Ben-Horin & Roll 2012). When comparing projects that do not have similar useful lives, the IRR is preferred to the NPV method. It is because the results can be easily interpreted (Ross et al. 2005).

The NPV approach is preferred in most instances to the IRR given its consistency. The consistency comes at the expense of convenience and ease of interpretation of investment appraisal results. The disadvantages of the Net Present Value technique are highlighted by NIlles (2006) who proposes as follows. The IRR is the most suitable investment appraisal tool. Both the IRR and NPV result in similar accept and reject decisions for particular projects being evaluated. Hardaker (2004) consider the NPV approach as the most appropriate investment appraisal tool. The approach has an easier computational procedure when compared to the Internal Rate of Return. However, the IRR is preferred because it expresses the results in a form of the compound rate of return. It, thus, makes it easier to make comparisons on similar investment opportunities when compared to the NPV approach (Ross et al. 2005). It is imperative that organizations use the two methods of investment appraisal before undertaking the final investment decision.

NPV and the Discounted Payback Period Method of Investment Appraisal

A project’s Discounted Payback Period Method is the time within which the discounted net cash flows of the given project taken to repay the initial outlay cost (ACCA Global 2015). The discounted PBP states that managers should only undertake those projects that can pay back the initial outlay cost within some stipulated time. The timeframe can be stipulated by the management’s internal factors or the external factors related to debt management. According to Brealey, Myers, and Allen (2005), the discounted PBP is less useful in investment decisions compared to the NPV technique. It is because it does not take into consideration some discounted values of cash flows after a payback period. In addition to this, the discounted PBP technique is flawed because it doesn’t take into account the timing of cash flows being generated before the payback period has been reached.

Wilkinson (2013) prefers the NPV method to the discounted IRR technique. The latter has a series of flaws that may lead to wrong investment decisions. It is being made acceptance of the project that should have been rejected or failed to accept the project accepted. The discounted IRR ignores the effect of risk, time value of money, financing factors, and inflation. These factors are critically considered in the NPV approach. Also, the discounted PBP is based on the assumption that the project’s cash flows after the payback period have no effect on investment decision-making (Wilkinson 2013). The limitation makes the NPV method more superior than the discounted IRR. It considers all the project’s cash flows over its useful life. The discounted PBP, on the other hand, only finds the maximum possible timeframe in which the initial outlay will be recouped. On the contrary, Hong-Jen (2010) proposes that managers should employ the discounted PBP approach in investment appraisal. The project evaluation technique is hugely important to financial managers. It adequately describes the risk and liquidity of projects that have constant cash flows (Hong-Jen 2010).

Conclusion

The Net Present Value appraisal technique is broadly used in most firms given as follows. It considers risk factors, the time value of money, and some changes in inflation. The NPV rule is best applicable when analyzing mutually exclusive projects rather than independent ones that require the use of IRR and discounted PBP methods. It is important to make the correct NPV investment decisions given the long-term implications of the capital-intensive projects. The NPV approach is advantageous. It gives investors the present value cash values of any investment. Besides, this approach is easier to identify profitable and unprofitable investments given its ranking procedure. However, its effectiveness in long-term investment decision-making is limited since it ignores the interest rate sensitivity. The uncertainty of interest rates is, however, considered in the Internal Rate of Return project appraisal technique. The Discounted Payback Period Method fails to specify the investment decision-making criteria among competing projects. It is, however, very useful as it highlights the maximum acceptable timeframe for the firm’s investment.