250 words Why does traditional NPV analysis tend to underest

250 words

Why does traditional NPV analysis tend to underestimate the true value of a capital budgeting project?

Solution

Net Present Value is the present value of future cash flows due to the project in excess of the initial investment. If NPV is greater than 0 the project is accepted for independent projects. For mutually exclusive projects higher NPV project is chosen.
However NPV underestimates the true value of the project because of following reasons:
1. NPV assumes that the cash inflows or outflows are reinvested at WACC which might underestimate the project. However the cash can be reinvested at higher rate compared to WACC which can give a higher NPV which might make the project suitable over others.
2. NPV is calculated at target debt equity ratio. However, when target debt equity ratio changes then WACC keeps on changing and this makes calculation of NPV is difficult. Moreover, if in future WACC reduces then NPV will be underestimated for fixed WACC issued for calculation.
3. NPV fails to calculate increase in value in case a project is stopped and is reinvested to a higher NPV project. It does not help in deciding whether to continue or discontinue a project in case it is started.
4. It excludes the idea of real options. Some projects might not be profitable for certain period but when executed can generate huge cash flows in future as it might allow to start a new project. Such projects cannot be calculated or value using NPV. NPV of research and development can’t be calculated using NPV because future cash flow can’t be estimated for such project. But the actual value of such projects might be very high.

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