Background
The net present value (NPV) refers to the difference between the present value of all projected cash inflows of a project and the present value of cash outflows (usually the initial amount of investment) of that particular project over a given period of time. NPV is the most commonly accepted measure of a project’s viability and is the most commonly used in capital budgeting. For most profit seeking institutions, a positive NPV gives a go ahead to the implementation of a project, (Kurt, 2018). NPV is also used to choose between projects in case of multiple options, in which case the project with the highest NPV is favored over the others.
However, situations do arise where firms undertake projects with a negative NPV. This can arise from considerations such as consumer expectations and a company’s legal environment. More often than not the negative NPV is as a result of businesses not being able to quantify the benefits of a project leading to the classification of such as non-financial factors of project valuation. Other times it is because rather than the project being undertaken to make things better it is adopted as a necessity to prevent things from getting worse. It thus features as an expense in valuation without a quantifiable benefit that can be included in analysis, (Milano, 2017). Some of the factors that could lead to this are briefly outlined below as well as the role they play in project selection.
Every company has a vision, that is where it wants to be and a mission, what it needs to do in order to achieve its objectives. The first step in investing is the identification of a need based on the objectives of a company. The other consideration in need identification is the consideration of where a gap exists in customers’ needs and preferences, (Wilkinson, 2013). For any given project a company wishes to undertake, a strength weakness opportunities and threats(SWOT) analysis must be conducted to ensure that despite the NPV analysis conclusion arrived at, whatever project is picked it’s in line with the company’s objectives, mission and vision. This tool is a key factor in the final consideration of a project as it reconciles both the financial and the non-financial aspects of project selection. Therefore, despite a project having a very promising prospect the less favored, in this case say one with a negative NPV can be picked if it is best in line of corporate strategy, (The WritePass Journal, 2012).
Voice of Customer
The external stakeholders include its customers, government and the community at large. Whatever action a company takes it affects the community one way or the other. Its good efforts endear the society to the company increasing its customer base in the long run as compared to say if the company happens to be a great environmental pollutant endangering the lives of the community. Therefore, a company may choose to implement a project with low or even negative NPV in a bid to secure community support thus maintaining their customer base especially in a competitive market environment, (Ramahi, 2011). A project that compromises societal values of the community in which it operates should be avoided despite the accompanying financial lure it might hold, (Roy, 2018).
The government affects business operations through the enactment of legislatures that regulate the environment in which they operate as well as the way in which they operate. Each country has set laws and regulations that businesses and companies are required to abide by. A project could upon evaluation be very promising but if the government outlaws such an undertaking it then can’t be actualized, (Shapiro, 1978). Many countries for instance have laws regarding employees’ compensation and pension schemes. In the case of pension, a company has to contribute a given amount on a monthly basis towards the retirement scheme of the employees regardless of their productivity and which has no direct benefits to the corporation. Every country has a governing body that is charged with regulating the quality of goods and services that are consumed and produced in that country as well as regulating the prices to ensure consumer protection. This may not always go well with the financial objectives of a company but it then has to adhere to the stipulations for it to be sustainable. (Nodson, 2017).
Senior management may decide to implement some projects with regards for their employees, product lines and competition. Employees play a very important role in any organization as they are the ones responsible in actually implementing the companies stipulated activities as outlined by the management towards the achievement of its objectives. Therefore, their safety and morale is a critical matter for each organization. A company may thus undertake projects to safeguard the safety of its employees for instance through training or purchase of safety gear. This dips into their pockets without a necessarily positive reflection in their NPV other than the smooth functioning of the company, (The WritePass Journal, 2012).
Business Risk Management
Competition is another arena which could lead to a negative NPV but which many firms must undertake. One way not to be outsmarted by company rivals is through advertising in the mass media. This must not necessarily translate to greater sale volume or revenue especially if the competitors are also heavily into advertising. It merely acts as a tool of maintaining customer base and relevancy. Competition can also be achieved through introduction of new product lines. Shoppers for instance prefer to shop where they can get everything under the same roof rather than move from one place to another. In this case it makes perfect sense for a corporation to introduce whatever product it is that could make their customers seek out their competitors or risk a shrink of their customer base. Despite of the poor feasibility of the new product the good business will write it off in the long run, (Batra and Verma, 2018).
At the end of the day the senior management has the final say concerning what project to undertake especially where there exists a disparity in the financial and nonfinancial aspects of projects. After all analysis and considerations together with recommendations have been tabled the management conducts a thorough analysis of all facts and decides on the best project to undertake, (Wilkinson, 2013).
Whenever a project is picked a company most often has a timeline for instance of when they expect the project to pay off the invested amount, that is the payback period,(Lan and Viet, 2018).Also when calculating the NPV a given number of years is picked say 10 years in discounting expected cash flows. However, this does not mean that beyond that period of 10 years the project will not be generating income. As a result, in the computation of the NPV in that period it is entirely possible to get a negative one which ultimately in the long run will translate to a positive NPV, (Kester, 2018).
Another important economic factor to consider is customers demand. Whatever project undertaken should want to fill a niche in the customers’ needs and services. What will the quality of product or services, how will they be priced? are some of the things that should be considered in choosing a project to ensure that it is just not viable on paper. This is because the above factors are a determinant of demand and as such will determinant the success of a project once it is launched, (Wetzstein, 2013).
Corporate’s Strategic Framework
Despite the attractiveness of a positive NPV as a basis of project selection, a negative NPV should not be disregarded without a thorough evaluation of the necessity of the project for the sake of the business going concern even beyond the valuation period as it could provide the means to maintain and even expand the company’s market base in later years. The most important factor in evaluating projects with a negative NPV is to ensure that it is strategic, that is, despite the benefits being difficult to quantify or even taking a super long time to materialize there are still justifiable benefits. In addition to the project being strategic, one with the least negative NPV is desirable, (Milano, 2017).
Before a project is selected a number of considerations must be made even after financial evaluation is conducted. This is to ensure that despite the NPV outcome the project addresses customers’ needs and expectations, meets its legal obligations and is in line with the company’s mission and vision.
Batra, R. and Verma, S. (2018). Non-financial criteria in project appraisal methodologies: empirical evidence from Indian companies. International Journal of Accounting and Finance, 8(1), p.80.
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Wetzstein, M. (2013). Microeconomic Theory: Concepts and Connections. Routledge, 2013, p.165…
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