Sry if this is a newb. question. When NPV=0, the firm size increases but shareholder wealth does not increase. Should the project still be undertaken if no foreseeable +NPV projects exist???
Indifference. You might as well return the $$ to the shareholders (pay dividend or repurchase shares).
If you’re in manufacturing, would you continue with your project and basically only cover your costs or would you let go your employees?
To invoke an economics concept, wouldn’t this be similar to a normal profit situation?
I think so, is the minimum necessary to keep things running (nt that shareholders would be happy about it).
that is identical to normal profit situation.
i think it would depend on what other projects you can put the money into. If you have nothing that can reproduce the Required rate of return, you would probably want to take the project. If there are possibly more projects in the future that would have a higher NPV, … or other mutually exclusive projects with higher NPV but if the project is independent, not being involved in the project can still return the Required rate of return with little risk, the project should not be taken. I had a question in the schweser QBank, and the answer for taking a NPV=0 project was to not take it.
NPV is 0 when the discount rate is IRR. Discount rate represents the opportunity cost for the project or the cost of capital. Would you rather pay back your debt and attain the same IRR without using your employees to do the project with 0 NPV or would you employ your resources and do a project that returns the cost of capital? I think it would make sense to do the former.
isn’t that assuming that financing is through debt? what if the financing is entirely through equity? and there are no alternative projects?
The discount rate takes into account financing costs via debt and equity. That is the reason that capital budgeting does not include financing costs since they are incorporated in the discount rate.
If the NPV=0, it makes no sense to take the project. Once you start justifying taking the project with various reasons, like it may be good for the company later on, or that employees would be idle, etc, then you are basically saying the NPV>0. So, there is no if, but, what if, etc. If its NPV=0, that’s it. Throw it into the trash. yes/no?
You’re discounting at the required rate of return, the minimum rate of return with all the risk premiums, capital costs, and other adjustments factored in. If you expected more, then why not simply increase your discount rate? If you earn what’s “required,” why wouldn’t you take the project? Only reason I can think of is that there is a better alternative elsewhere, be it another project or going out of business and using your resources elsewhere. A positive NPV illustrates excess returns–IRR > k. It’s value generated over and above what’s expected after factoring your cash flows through TVM. Risk is paired with return and is incorporated in your discount rate. The IRR that generates a NPV of 0 represents the point on the linear relationship of risk and return for a project. This is very similar to the SML and calculating alpha for an investment. The twisted thing about the NPV value rule is in the real world, firms sometimes will take a negative NPV–the interpretation is based on how broad or narrow you define a “project.” Reason can stem from business strategy. Think of a loss leader strategy. Or environmental cleanup. Intangibles are difficult to measure in financial terms. How do you quantify human capital? Then again, who cares? NPV is one rule amongst many used in capital budgeting. Namely, it is a time-value oriented tool used in measuring cash flows.
What about the stakeholders (minus the shareholders)??? Assume no forseeable project exists with a +NPV
gdiddy, Good post. When you say that if you earn what’s required, why wouldn’t you take the project? Well, thats because your then earning only your opportunity cost (next best option to that investment which also includes paying back debt like I stated earlier) and you would rather do that than take on a project with 0 NPV. As far as increasing your required return, well the higher the NPV the higher the return above the required return and thats why you pick the project with highest NPV. Last point is on the difficulty to measure intangibles – capital budgeting does not take into account intangibles becuase it assumes that they are going to result into a cash flow at some point during the project. Finally, NPV is one of the tools but its probably the best one and hence the most important. CFABLACKBELT: If there are no projects with +NPV, the company will not undertake any projects and will probably return residual income from current income streams in the form of dividends to the share holders.
IF there are no projects with +NPV there will be no residual income. Residual Income for any period = (ROE - Re)* BV(Equity) With no +NPV projects, ROE = Re and Residual income=0
Interesting posts guys. Thx!
Thanks adb258 and gdiddy. Some reason my brain just stalled when i was thinking about that question.