Question

The NPV decision rule says to accept the project if the NPV is greater than zero. You perform a thorough capital budgeting analysis on a project that requires a $1,000,000,000 initial investment and calculate the net present value (NPV) as $1. Following the rule, you tell your boss she should accept the project. She laughs and says “do you think I would really invest $1,000,000,000 for a measly $1 NPV? You should be fired” How would you respond to her?

Answer 1

Net Present Value (NPV) is calculated by discounting the future cash inflows at Minimum Acceptable Rate of Return (MARR) and then subtracting the initial investment.

$1 NPV does not mean that the profit is $1.

$1 is the wealth created for the shareholders after providing for the required return to the shareholders.

While deciding on the MARR , the cost of capital and the project risks are also taken into account.

Hence ,the investment opportunity of $1,000,000,000 will be an opportunity for the organization to grow after making the required profit and providing for all costs including costs of debt.

If the company can arrange for the required capital and if there is no other better opportunity, this project should be considered as opportunity to grow and should be taken up