This is the second example from my list of “top two problems of the Net Present Value method”, and my personal favorite one.
Let us say that an investor is evaluating (thru the use of NPV) to invest in the creation of a new company that will manufacture and sell a new product. After all relevant forecasts (sales, purchases, salaries, ads etc) are collected, they are entered in a spreadsheet and they are discounted to their value on the starting day of the investment. The collections are portrayed as positive, and the payments as negative. In the end all discounted values are added, and we see if the result is positive (profit) or negative (loss). On that, we base our decision whether to make the investment or not. Or at least, that’s how it went thru the method of NPV. Now, let us insert in the scenarios one new information and see what happens.
Low scenario: The investor contributes 1 mil USD as equity. In reality, we see that the project is underfunded, and accordingly will take bank loans to fund its operation. The result is that half of the gross profit will go to the Bank, for payment of “Interest Expense” (at 6%).
High scenario: The investor contributes 10 mil USD as equity. In reality, we see that the project is self sufficient and does not need bank loans. On the contrary it will collect some “Interest Income” (at 0.5%).
Mid scenario: The investor contributes 5 mil USD as equity. In reality, we see that the project will take smaller bank loans than the low scenario and accordingly pay less “Interest Expense” (at 6%) than the low scenario, and will collect less “Interest Income” (at 0.5%) than the high scenario.
Concerning the actual bottom line result, which is Fiscal Year end “Profit or Loss” (or even better, if you prefer, “Dividends Distributed”), we see that the three scenarios deliver three materially different results. All of the forecasts (sales, purchases, expenses etc) are the same in all three scenarios. Their only difference is the starting balance of the bank account (as it is affected by the investor’s contribution of equity).
With the use of NPV all three scenarios deliver the same result. The problem that creates that obviously illogical situation lies in the fact that the starting balance of the bank account (or for the matter its balance at any given moment) is not factored or calculated anywhere thru the use of the NPV method.
Stick around, and we are going to see more problems and inaccuracies of the “Net Present Value” method.