NPV stands for Net Present Value. NPV is present
value of all future cash inflows minus present value of all cash out
flows of a project under consideration. If NPV is greater than zero the
project is considered feasible. Discount rate is usually the opportunity
cost of capital.
NPV is considered to be the most reliable techniques
for project evaluation. Since it is in use for years so it has developed
an unswerving repute in financial analysis. This notion is taken as it
was presented years before without any momentous modification. The core
concept behind making any investment is to maximize the shareholders'
wealth and so this instrument is used as a critic to evaluate the
investment opportunities. This paper tries to revise the use of NPV to
evaluate a project in context of maximizing shareholders wealth.
Modification suggested here is in deciding the
discount rate of cash flows or in other words opportunity cost of
capital. In our point of view suitable discount rate is prevailing
Return on Equity (ROE) of the company.
Let us consider following project:
Table
1
ASSUMPTIONS 
Required Rate of
return for company considering its risk and various other factors
usually considered ( Company has no Loan) 
15% 
Return on Equity
offered by Company 
33% 
Table
2
PROJECT TO BE EVALUATED 
Cash
Flows 
Year 0 (Initial
Investment) 
(500,000) 
Year 1 
150,000 
Year 2 
153,750 
Year 3 
157,594 
Year 4 
161,534 
Year 5 
165,572 
NPV 
21,729 
Given below is present and forecasted income
statement of company which is considering this project. Returns with and
without undertaking the project are also given.
Table 3

Share
Capital 
1,000,000 
1,500,000 
Income
Statement 
Year
0 
*F
Year 1 
*F
Year 2 
*F
Year 3 
*F
Year 4 
*F
Year 5 
Sales 
1,000,000 
1,025,000 
1,050,625 
1,076,891 
1,103,813 
1,131,408 
COGS 
400,000 
410,000 
420,250 
430,756 
441,525 
452,563 
Gross Profit 
600,000 
615,000 
630,375 
646,134 
662,288 
678,845 
Operating Cost 
200,000 
205,000 
210,125 
215,378 
220,763 
226,282 
Earning Before
Interest & Tax (EBIT) 
400,000 
410,000 
420,250 
430,756 
441,525 
452,563 
Interest 
N/A 
N/A 
N/A 
N/A 
N/A 
N/A 
Earning Before
Tax 
400,000 
410,000 
420,250 
430,756 
441,525 
452,563 
Tax 
70,000 
71,750 
73,544 
75,382 
77,267 
79,199 
Net Income
* Forecasted 
330,000 
338,250 
346,706 
355,374 
364,258 
373,365 
ROE
(Without Undertaking Project) 
33% 
34% 
35% 
36% 
36% 
37% 
Cash Flow
(From Operation) 
380,000 
389,500 
399,238 
409,218 
419,449 
429,935 
Rate of Return in
Form of Cash Flow 
38% 
39% 
40% 
41% 
42% 
43% 
Cash Flow of
Company Combined with Project 
 
539,500 
552,988 
566,812 
580,982 
595,507 
Rate
of Return in Form of Cash 
Flow after
Undertaking the Project 
 
36% 
37% 
38% 
39% 
40% 
Depreciation
Expense 
50,000 
51250 
52531 
53845 
55191 
56570 
Company is considering the project which requires
initial investment of Rs. 500,000 and will generate cash flows as shown
in table 1. Company has no loan and is totally financed by equity
capital. Required rate of return of company is 15% and as company is
quite efficient so it is paying above average returns. Company has ROE
of 33% & Cash flow return of 38% as shown in table 3.
NPV is a tool which is based on cash flows so return
on cash flows for the company in above table is separately calculated
for each year and decision would be based on return on these cash flows.
Table 2 shows that on base of NPV project is
feasible. But if we look at table 3 it is obvious that rate of return on
equity in form of cash flows is decreasing if company undertakes the
project.
So it is obvious from above discussed case that due
to wrong selection of opportunity cost, the rationale of company i.e.
maximizing the share holders wealth has failed as return on equity has
decreased after undertaking the project.
If company chooses current ROE as discount rate NPV
of project will be negative and company will reject this project.
In same way suppose if ROE of company is less than
required return, than a project giving less than required return but
greater than prevailing rate of return would also be rejected on basis
of prevailing method of selection of discount rate. But if we take
current ROE as discount rate we shall select that project and it will
obviously result in improving ROE of company and thereby increasing
shareholders wealth.
If company has two or more alternatives than project
with higher NPV resulting from considering ROE as discount rate should
be undertaken.
