Many textbooks and websites say when NPV = 0, the company will be indifferent to investment.
But I believe that when NPV = 0, the decision should be to go ahead with investment as , the company is able to earn a return that is exactly equal to required rate of return. When a company is able to gets its required rate of return should not it go ahead with investment rather than staying indifferent ?
Please provide detailed clarification on this. Thanks.
A company exists to meet the common shareholder’s expectation.
If common shareholder invests money in a company, to earn a certain a return on their investment , say 8% , the company should do it simply for the reason that common shareholders are the owners of the company and owners want / require 8%. Can the company say to common shareholders , you will get 8%, but what is in it for me?
Another argument could be this … if NPV=0, it means the company is able to provide salary to all its employees working on the project and also satisfy investors.
So, the company should go ahead with project when NPV = 0.
Thanks again for the reply. Your inputs are valuable.
This assumption that NPV should NOT be used as a tool for evaluation if the financing is going to come from existing funds is strangely missing in many textbooks. Please let me know if you have any links to reliable websites that says so.
If the common shareholders are willing to invest IN FUTURE and tell the company that they will be very happy with, say 8% return, and the project NPV yields 8% for the FUTURE PROJECT, should not the company go ahead with the project ? or should the company tell its common shareholders …with 8% you will be very happy but what is in it for the company?
Shareholders care about their equity. On a zero NPV project (the present value of the project’s cash flows minus costs is “0”), why would shareholders be happy. A company should seek projects that increase shareholder value through a positive return on their investments that then increases the value of equity.
If there are non-cash reasons to do a zero NPV project (such as estimated future synergies or growing a division to look good for an acquisition), then yes it can make sense. Otherwise, as all the textbooks are telling you, the decision will be an indifferent one.
What folks are saying here is if I the company management told you the shareholder I just invested money in a project that will earn 8%, but the costs of the project entirely cancel out any gains from it so it’s a net zero effect, you would correctly ask me why I am spending company time and resources on this project that has a zero net return. And the answer would need to probably be for business strategy not pure financial reasons. Otherwise it is at best an indifferent choice and at worst an opportunity cost due to resources better allocated elsewhere to something better.
For this reason, NPV trumps IRR in project decisions. This is easily googlable if you search, especially since you can have scenarios where there is a positive IRR but the NPV is actually negative. cheers and all the best to you sir
When NPV = 0, the firm is indifferent which implies that it is neutral towards the investment. If investors can get a return higher than the required rate of return, it would only make sense for the company to distribute its retained earnings to its investors. However, if alternative investment opportunities look bleak, the company is better off by investing in the project. In conclusion, the company has some discretion when NPV = 0 and in essence, the large investors would get a say.