Question

Using the NPV bid price method, a construction firm submits a bid to build an apartment building, wins the bid, and proceeds to complete the building. After the project is completed, the company's CFO is puzzled by the fact that the company lost money on the project. If the CFO used the correct method for calculating the NPV bid price , how could this have happened?

Answer 1

ANS: Decisions taken on the basis on NPV fails or becomes less profitable in rarest of rare circumstances, might be due to some inherent limitations of NPV. NPV is calculated as difference of PV of Cash Inflow & PV of Cash Outflow. A profitable decision is based on positive NPV (i.e NPV greater than 0). We set NPV greater than zero or positive while calculating a Bid price, when we are finding the price at which we expect to create a positive wealth or maximise wealth for the shareholders.

Some times Decisions based on NPV becomes adverse, due to following points -

• NPV fails to consider the critical cost which has a major impact on the value of Investments.
• Under-estimating the Initial Outlay, as company fails to estimate the opportunity cost.
• Sunk cost are being ignored like- Preliminary cost , R&D cost , Start-up cost etc.
• Cash Inflow from projects sometimes estimated too high .

So, due to above reasons the decision taken by CFO based on NPV bid price method is not favourable for the company in terms of profit.