Risk is a deviation from expectation (Lecture 2). Every organization is subject to risk. However, setting expectations of an investment based on risk and return is key to obscure a company from bankruptcy and excess debt among other liabilities. Positive Net Present Value (NPV) gives a company the green light to proceed with an investment (Lecture, 2023). Negative NPV signals investment loss in the future. Nevertheless, we can adjust Negative NPV using diverse modeling strategies.
Adjusting discounted rates using a Modified Internal Rate of Return (MIRR) is one of the strategies suitable for adjusting negative NPV. Adjusting NPV using the Internal Rate of Return gives inaccurate results at times (Cundiff, 2023). MIRR gives a different discount rate for cash flows capable of giving results consistent with the NPV approach. Similarly, low discounted rates reflect low risk compared to higher discounted rates. MIRR with values higher than the operating cost increases the possibility of achieving positive NPV. However, a company must consider the uncertainty relating to inflation, future market conditions and investment defaults before falling for low discounted rates.
On the other hand, the payback period is the time taken for an investment to generate capital once the investment is made (Cundiff, 2023). The cumulative net cash flows must occur throughout the year and must sum to zero to realize capital. However, a modeling strategy is required to account for the cost of interest and bonds paid to banks and investors during the project’s life. Discounted Payback Period is the suitable adjusting strategy because the method uses the actual value of each cash flow, i.e., after subtracting all costs of interest. Using the formula, “Discounted Cash Flow (DCF) = Cash Flow/ (1+r)^n”, DCF must be positive for a company to invest in the project.
Additionally, an adjusted payback period gives a company the opportunity to compare projects with different cash flow patterns and return periods. Therefore, it is possible to select discounted rates that maximize net present value (NPV) because the adjusted payback period takes into account the time value of money and the actual profitability of an investment in its lifetime. However, a company needs to consider important factors such as inflation and opportunity costs to minimize the risk of losing investment capital.
Sensitivity analysis is also a method that can also adjust negative investment results from NPV, IRR and Payback models. Sensitivity analysis entails adjusting certain variables of an investment to overcome the negative result of an investment or business (Kenton, 2023). For example, when a company gets a negative NPV for a project, the company can decide to alter certain variables such as sales volume, pricing and operation costs. When the sales volume increases, more income is generated to maximize NPV. Similarly, when the price of stock is increased, NPV is maximized, shortening the payback period. Lowering operation costs will also increase annual cash flows.
Adjusting the weighted average cost of capital (WACC) can also help a company achieve positive projections of NPV, IRR, Payback and other capital investment models. Adjusting WACC involves reducing the cost of debts by negotiating low-interest rates with lenders and lowering the cost of equity (Maaji et al., 2019). When the financial returns expected by investors are lowered, the company can easily maximize NPV for a minimum Payback period.
References
FIN 620 Lecture Capital Investment Decisions (2)
FIN 620-session 3 lecture (2)
Kenton, W. (2023). Sensitivity analysis definition. Investopedia. https://www.investopedia.com/terms/s/sensitivityanalysis.asp
Maáji, M. M., & Barnett, C. (2019). Determinants of capital budgeting practices and risks adjustment among Cambodian companies. Archives of Business Research, 7(3).
Task 2 and Task 3_updated_Oct_19_21
write