Net Present Value (NPV) is used for estimating the future net cash flows of the project. For computing NPV, all cash inflows and outflows of the project are projected and then they are discounted back to the present date using a suitable discount rate (Ross, Westerfield, & Jaffe, 2013). The company’s CFO could be reluctant to accept the results of NPV based on the following concerns:
- The future cash flows of the project are based on assumptions and it could be possible that the actual results differ substantially from these projections.
- The discount rate used may not be consistent with the CFO’s anticipations.
- Non-cash items are excluded from NPV calculations.
In order to address these reservations of the company’s CFO, the following issues need to be addressed.
- Reasonableness of cash flow projections should be justified on the basis of the assumptions made for calculating NPV (Ehrhardt & Eugene, 2010). These assumptions should be based on the findings of market surveys, economic indicators reports, historical sales data, and studies regarding consumers’ behavior. Furthermore, the company should also corroborate projections of cash flows with other similar projects undertaken by the company in the past or by its competitors.
- The appropriateness of the interest rate used should also be justified on the basis of the reports issued by the central bank and various financial institutions as they continuously monitor interest rates. Therefore, the discount rate should also be in line with the market trend.
- Non-cash items such as depreciation and amortization are excluded from NPV because they do not involve any cash flow. However, they do add to the project costs in the long run (Danielson & Scott, 2006). Therefore, it should be justified that non-cash items are not material to affect the project’s profitability.
The CFO would still be reluctant to initiate the project as its NPV was only +$10, which is close to its breakeven point. A slight variation in the project’s estimations could generate losses from it. For evaluating the project’s NPV, it is important to estimate the project life correctly and make projections accordingly. In the given scenario, there was a possibility that the project life was wrongly estimated (Ross, Westerfield, & Jaffe, 2013).
If the above considerations do not convince the company’s CFO then the Internal Rate of Return (IRR) should be used to assess the project’s viability.
The Internal Rate of Return (IRR) is a technique that is used for estimating the discount rate at which NPV of the project becomes zero (Baker & Powell, 2009). The IRR of the project is compared with the company’s cost of capital. If the IRR of the project is greater than the company’s cost of capital, then the company should accept the project as it would add value to its business. Moreover, projects with higher IRR are prioritized for investment.
The benefit of using the IRR is that it provides comparison with the internal cost of capital. On the contrary, NPV uses discount rates that are obtained from external sources. It makes IRR more relevant to the company’s internal decision-making process (Ross, Westerfield, & Jaffe, 2013).
However, it becomes difficult to compare the IRR of different projects with unequal lives. In this situation, the CFO could use the Replacement Chain Method (RCM). The RCM is the extension of the IRR, which hypothetically adjusts unequal lives of projects for comparing their viability (Mayo, 2011).
References
Danielson, M.G., & Scott, J.A. (2006). The Capital Budgeting Decisions of Small Businesses. Journal of Applied Finance, Fall/Winter, 45-56.
Ehrhardt, Michael C., & Eugene, B. (2013). Corporate finance: A focused approach. Mason, USA: Cengage Learning.
Mayo, H. (2011). Basic finance: An introduction to financial institutions, investments and management. Mason, USA: Cengage Learning.
Baker, Kent H., & Powell, G. (2009). Understanding financial management. New Jersey, USA: John Wiley and Sons.
Ross, S.A., Westerfield, R.W., & Jaffe, J. (2013). Corporate finance (10th ed.). New York, USA: Mc-Graw Hill.