Now that you have finished finance, you know there are things that we know matte
ID: 1219506 • Letter: N
Question
Now that you have finished finance, you know there are things that we know matter and things that we think matter and things that we know very little about. Adopting NPV>0 projects is in the set of things that we know matter.
Required:
(a) Give a careful explanation as to why adopting NPV>0 projects is consistent with the goal of the firm.
(b) We recognize that in competitive markets, most projects will have a NPV=0.
(1) Give an explanation to an ECON104 (basic microeconomics) student about why a firm would take on such projects and what they have to gain or lose.
(2) Under what circumstances do we see NPV>0 projects?
Explanation / Answer
Answer (A) (Question - why adopting NPV>0 projects is consistent with the goal of the firm.?)
Net present value is a numerical calculation that shows the present value of an investment based on expected income from that investment in future years minus the cost of the project. Net present value is calculated by dividing the expected income of a project in each future year by a term equal to one plus a discount rate raised to a power equal to the year. The totals for each year then are added together, and the initial cost of the project is subtracted from that sum to arrive at the net present value. The discount rate represents the time value of money: the amount that could be made by committing the money to other opportunities.
According to the theory of net present value (NPV), participating in a positive NPV project will increase firm or shareholder wealth.
Positive Net Present Value
The purpose of net present value is to help analysts and managers decide whether or not new projects are financially viable. Essentially, net present value measures the total amount of gain or loss a project will produce compared to the amount that could be earned simply by saving the money in a bank or investing it in some other opportunity that generates a return equal to the discount rate. If a long-term project has a positive net present value, then it is expected to produce more income than what could be gained by earning the discount rate, which means the company should go ahead with the project.
Answer B) – (1) (Question - why a firm would take on such projects if NPV=0, and what they have to gain or lose?)
You are trying to find the Internal Rate of Return of an investment (by definition). By setting NPV = 0, you are finding the discount rate that will make the present value of the entire investment equal to $0 today. It is not that the present inflow or outflow of money is $0 today. What this means is that if you were expecting to make a return of the IRR, you would be indifferent between investing and not investing, hence NPV = $0. Background: A positive NPV means you will profit on this project/investment (after discounting the cash flows at your required rate of return). A negative NPV means you will lose on this project/investment. If your NPV is $0, you are indifferent. The IRR relates to the NPV. A project/investment with a positive NPV has an IRR above the required rate of return. A project/investment with a negative NPV returns less than the required rate of return. When the NPV is $0, the project returns exactly the required rate of return.
If a projects NPV equals 0? - On one hand, you accept a level of risk, knowing that if your projections are correct, there will be no profit. On the other hand, with this same assumption, you will be establishing a larger infrastructure with no cost. This may provide benefits down the road.
Zero NPV would imply that project's discount rate is equal to IRR. If investors are amenable to accept projects that would generate returns equal to discount rate, then zero NPV projects are fine.
1. Investors have no alternative with respect to capital deployment and they 'have to' deploy the capital (time constrained, excess dry powder).
2. Investors believe that applied discount rate is exaggerated and doesn't reflect the cost of capital (like effects of financing) or the risk associated with project
3. Project is acceptable.
Answer B) – (2) ( question : under what circumstances do we see NPV>0 projects?)
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