ROE plays a dominant role in decision making of
investors. To maximize share holders' wealth which is prime goal of
every organization, it is necessary that company must try to increase or
maintain current ROE. So while considering a project current ROE should
also be considered as important factor. Declining ROE results in
decreased share price and company feels difficulty to get investment
from equity market.
Net Present Value (NPV) is an important measure of
project evaluation.
"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".
In general practice required rate of return on equity
investment in company is taken as opportunity cost of capital while
calculating NPV. If current ROE of company is greater than required rate
of return, which is usually the case with growing companies than a
project taken on the basis of positive NPV calculated by considering
required rate of return on equity investment might decline over all ROE
of company. For example a company whose required rate of return is 30%
and current ROE is 40% will take a project whose return is 31% because
of positive NPV but this project will bring overall return of the
company to a level of less than 40%. In other words shareholders wealth
will deteriorate.
In an article "NPV: Meticulous Measure of
Project Evaluation?" written by me and Mr. Rehan Muneer Malik and
published by Pakistan and Gulf Economist we suggested that
current ROE should be taken as opportunity cost of equity in case the
company has current ROE greater than required ROE.
It was pointed out by some analysts that in this case
a lot of projects will be rejected and company will be left with very
few or no options. In this article I shall try to prove that it is not
necessary to reject a lot of projects by following our method of
calculating NPV. I am of the opinion that by Recapitalization of
projects a lot of projects can be made feasible in terms of ROE.
"Recapitalization is changing the debt and
equity mix of the project to get targeted ROE"
Two step approach towards project evaluation is
suggested here.
STEP 1
Calculate NPV of the project by using current ROE (in
case if company is earning above required ROE) as cost of equity. If NPV
is positive accept the project if NPV is negative follow the second
step.
Let us consider the
following project.
NPV is negative so we shall follow the second step.
Investment
(once at Start of Project)

1,000,000 
Individual
Weights 
WACC 
Loan 
400,000 
40%
60% 
34% 
Equity 
600,000 
.

Weighted
Average Cost of Capital (WACC) 
34% 
Interest Rate
Required Rate of Return on Equity
Cost of Equity
Cash Flow 1 (C1)
Cash Flow 2 (C2)
Cash Flow 3 (C3)
Cash Flow 4 (C4)
Cash Flow 5 (C5)
Cash Flow 6 (C6)
Cash Flow 7 (C7)
Cash Flow 8 (C8)
Cash Flow 9 (C9)
Cash Flow 10 (C10) 
25%
30%
40%
350,000
350,000
350,000
350,000
350,000
350,000
350,000
350,000
350,000
350,000 
NPV 
(19,207) 
STEP 2
For recapitalization we have to find out that what is
the minimum level of debt & equity in the capital structure of
project in order to make this project feasible in terms of ROE. We know
that minimum acceptable NPV is 1. And at this level of NPV it means that
project is almost giving ROE of 40%.
Details of calculations are given at end.
Investment 
1,000,000 
Individual
Weights 
WACC 
Loan 
468,315 
47%
53% 
33% 
Equity 
531,685 

Weighted
Average Cost of Capital (WACC) 
33% 
Interest
Rate
Required Rate of Return on Equity
Suggested Cost of Equity
Cash Flow 1 (C1)
Cash Flow 2 (C2)
Cash Flow 3 (C3)
Cash Flow 4 (C4)
Cash Flow 5 (C5)
Cash Flow 6 (C6)
Cash Flow 7 (C7)
Cash Flow 8 (C8)
Cash Flow 9 (C9)
Cash Flow 10 (C10) 
25%
30%
40%
350,000
350,000
350,000
350,000
350,000
350,000
350,000
350,000
350,000
350,000 
NPV 
1 
Thus from above example it is clear that just by
changing capital structure we can make a project feasible in terms of
ROE. It also shows that 47% of debt and 53% of equity is minimum
required capital structure of the project to gain targeted ROE.
If this capital structure is not affordable for the
company i.e. may be prudential regulation doesn't allow more than
certain level of debt etc. than project will be rejected.
[NPV= C1/ (1+i) + C2/ (1+i)*(1+i)....................
 Initial Investment (Equation 1)
As (i) is Weighted Average Cost of Capital (WACC) =
Weight of loan * interest rate + Weight of equity * ROE (Current)
OR
WACC = Weight of loan * interest rate + (1 Weight of
Loan) * ROE (Current)
Putting above value of (i) in Equation 1 and
interpolating it for weight of loan we get the requisite weight of loan.
From this we can determine weight of equity also.
Other values placed are.
NPV= 1, ROE=40%, i= 25% and all values of cash flows
and initial investment as mentioned in tables.]
Special acknowledgement is due to Mr. Hashir Ibne
Irshad, Faculty member, Foundation Institute of Management &
Computer Sciences who has pointed out various valuable point in previous
article which acts as starting point of this article.