Question

As you know, investment analysis/capital budgeting is a two step process. Assume the first part of an investment analysis results in the second part being conducted. The second part returns an unfavorable answer. What are three things that you can do that would result in the investment being made?

Answer 1

So investment analysis being the first step has resulted in a project being taken to the next stage being project evaluuation using Capital Budgeting.

There are several steps in investment analysis which includes:

Fundamental Analysis

Risk Profiling

Technical Analysis

and Market Study

Once these steps have been crossed, there could be the next stage of Capital Budgeting.

During capital budgeting certain reasons could be there for the NPV to be negative:

1. Expected Cash Flows are low

2. Initial Investment too high

3. WACC implying the discount rate could be too high

4. Cash flows to be projected for x no of years could be lesser than the full period of the cash flows.

Some of the factors above can be remedied, for instance since Cost of Equity is a blended cost of equity and debt, and we know that equity is costlier than debt, better debt leverage can reduce the discount rate, thereby improving the NPV.

Secondly whether the initial investment can be done in traches needs to be evaluated, for an NPV point of view, the more a cash outflow can be deferred the more the NPV can be remedied.

However the fact of NPV being negative could also be due to Cost of Capital being too high, if there are other factors that can signify value creation for the promoters, and their required rate of return being too high, then the same needs to be relooked at , and the project could be looked at, assuming the estimates made are conservative, and there is a scope for over achievment of the project.

Sometimes certain acquisitions could be for the overall stragegy of a firm :

1. Competitive pricing to capture market

2. Acquisition of competitors, or acquiring key assets, that we do not want competitors to acquire

3. Doing a project heavy on marketing side, where the focus is on developing brand image and consumer recognition rather than profit.

4. Projects with a customer acquisition mode (which is the prime target of many startups), rather than profit, since there is a huge availability of funding, and for the time being profit is immaterial compared to acquisition of customers.

In the above scenarios, we can accept negative NPV projects.