Question

When a project entails significant social costs, the private net present value—the value of the project to its sponsor—exceeds the true (societal) net present value, namely the combined value to all the affected constituencies inclusive of the social costs.

• Should the externalities be taken into account when evaluating such a project?
• In your response, identify stakeholders’ roles, legalities, guidelines, policies or processes that might be considered/required to ensure a sponsor’s compliance or curb undesirable behavior?

(See Finnerty Chapter 6)

initial post should be brief and approximately 400-500 words.

Answer 1

Net present value is one of the criteria used in investment decision making. It measures the present value of net cash flows to the entity. It is measured by deducting present value of cash outflows from present value of cash inflows. The investment is made if NPV is positive.

While making the decisions relating to investment, the company must also consider the externalities. Externalities are the other effects of choosing an investment, which result in social costs. Externalities may be internal or external. Examples of internal externalities include removal of manpower due to automation of a process. This will result in loss of employment to human resources. External externality would be pollution caused due to release of gases from a process. This has a social cost of reducing the effects of pollution and saving the environment.

As these social costs cannot be accurately measured, they do not from part of formal calculation of NPV while making investment decisions. However, the companies need to consider these in making decisions, as real NPVs after considering the externalities would be far lower than the actual NPVs. Though externalities cannot be quantified with certainty, they must be estimated and made part of decision making.

The company must implement policies relating to externalities after obtaining approval from shareholders, Board and other stakeholders. The decisions made by the company effect variety of users like shareholders, creditors, employees, general public, government, etc. The company must consider the effect on all stakeholders before making an investment decision. To ensure a standard practice across the organization, the company may draft policy relating to factors to be considered in investment decisions and implement organization wide.

The company may identify the possible externalities considering the investment decisions made in the past. The externalities along with actions to be taken in each case, may be drafted and implemented. The legal considerations (especially the Environment Acts) should be considered before implementing the decision. The company may also conduct frequent training programs to employees working in the respective Investment decisions department, to educate them about the company’s policy.

The company is not legally mandated by Companies Act or similar acts to consider social costs in feasibility study. However, the companies should identify that the social cost may also be incurred in the future if other Acts are not complied with. The loss of employment affects human resources, and thereby has an impact on government’s policies relating to corporates, and public perception of corporates. Hence, companies must include all the factors in decision making criteria.