Question

Suppose you have calculated a $1,500,000 NPV for a capital investment by discounting the investment’s expected future cash flows (over the expected 5 year operating period) using the firm’s current cost of capital and after subtracting the upfront costs associated with the investment. If you accept this investment, which you should do given the $1,500,000 NPV estimate, discuss why the investment is not guaranteed to increase firm value.

Answer 1

The investment is not guaranteed to increase the firm value because of the following reasons

1. The expected cashflows are generally based on forecast and are not guaranteed (like those in saving accounts or fixed incoem instruments)

2. The firm's cost of capital is based on market values various components of debt, equity etc. The market values may change and thus the cost of capital may change leading to a different NPV (Actual)

3. There may be unforeseen costs associated with the project

4. The life of the project, salvage value and other forecasts may not be correct

5.Tax rates, govt. policies etc may change leading to different NPV

Thus, investments with positive NPV are not guaranteed to increase firm's value.

This is the reason that along with NPV calculations, firms also go for Scenario and Sensitivity analysis.