Academic Q: Are principal return requirements included in the discount rate? Should you accept a project w/ zero NPV?
Two part question.
Realize that the discount rate one should use is the cost of capital. Let's say, for example, that this is a firm w/ two principal employees who each dictate that they need a minimum of 8% per annum return to invest in deals of this risk level. There are no outside investors. No debt. No additional costs to factor in.
a) Under this scenario, if an 8% IRR deal comes in, NPV is equal to zero; should they take the deal or decline? Why?
b) Trying to understand the counter-intuitiveness of accepting a deal w/ a low NPV / an NPV of "1", for example. Law states that you should accept any NPV > 0 (withholding my question above), but in and of itself (not compared to other deals) how is that true? Why would you go through the effort and strain of closing a giant deal if it's dollar impact to your bottom line is "1"? Or is this incorrect?
Thanks
a) Depends on what exactly you are doing. You can "cheat" IRR by inflating it with various methods, which I hope your instructor covered. You cannot "cheat" NPV, however. Given NPV is 0, it is probably best you do not take the deal if you abide by only taking deals where NPV > 0.
b) You should always take deals where NPV > 0 if assumptions are true (the NPV value isn't based on some scenario analysis etc). "The effort and strain of closing a giant deal" should be included in the NPV value on the get-go so the "1" return have already considered all of those costs. Whether you think that is worth it is a value judgement outside of the investment policy you outlined (NPV > 0) but on a purely theoretical basis you should take it.
b) You're saying that the discount rate I've factored into the CFs should have already factored in the level of riskiness and size of transaction / work required to obtain those CFs? Yes?
In that sense, shouldn't I still accept deals w/ NPV = 0? It's exactly hitting my return hurdles, (assuming principal/firm owner return requirements are factored into cost of capital, a question that was initially posed and not answered...).
My issue would be that certain instructors claim cost of capital or discount rate is effectively your cost of obtaining outside funds or your cost of borrowing. Under this premise, obviously doing a deal that returns NPV of 0 would make you indifferent to doing the deal.
However, if the firm's internal return requirements above and beyond their cost of outside capital are factored into the discount rate, then I would assume that you would take any projection with NPV = 0, assuming the project is not being compared to anything else. That would imply that your return hurdles for the level of risk involved in the project are being met with what you expect to obtain. That is generally a good thing..deals are not infinite or available at your command..when you find a deal that meets your return expectations, would you not take it?
So many people seem to have differing explanations on this for some reason.
Major error in your thinking: you need a deal specific IRR, not a investor specific required return. The discount rate of the project should reflect the risk of the project.
Anything with NPV > 0 is value creating (if all assumptions are valid) and should be accepted unless you have restrictions on capital or liquidity.
For example: project 1 has a NPV of 1 which consists of 50% chance of -98 and 50% chance of +100 --> if you go bankrupt in scenario 1, you have restrictions on capital and/or liquidity.
Hm. Isn't my discount rate = required rate of return to take on the project? In that sense, if a project is meeting my exact return expectations, that is, my discount rate = IRR, then my NPV will be zero. There will be no "additional" value creation to the firm at that level above and beyond what was expected. At an NPV of 0, I'm still making an expected, risk-adjusted return on the project - I'm definitely still profiting, but there is no additional value ABOVE and BEYOND what was expected going towards the firm?
In that case, I should accept all projects with NPV > OR EQUAL TO 0.
So you are looking for projects that match your required return instead of the other way around ?
If NPV = 0 you make no economic profit. With leverage you can make the same expected return in the public market, and as it is diversified probably even better returns at same risk appetite.
As said; with NPV > 0 there are considerations like limitations in capital (creating opportunity costs) and risk appetite (do your financiers like projects with a 50% discount rate in Zimbabwe :)?).
Delete
Voluptatibus aliquid quo exercitationem exercitationem inventore eaque dolor. Commodi in impedit non provident optio ratione est. Excepturi sed facilis est vel error nobis.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...