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1- NEW INITIATIVE IN PRIVATIZATION AND INVESTMENT
2- REVENUE COLLECTION FOR THE FIRST SIX MONTHS
3- PAKISTAN: THE BEST PERFORMING EQUITIES MARKET
4- NATIONAL SAVING SCHEMES
5- TRANSFER PRICING BY MNCS
6- NPV: METICULOUS MEASURE OF PROJECT EVALUATION?

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NPV: METICULOUS MEASURE OF PROJECT EVALUATION?

 

By Rehan Muneer Malikand Muhammad 
Farrukh Rasheed

Jan 13 - 19, 2003
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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.