Net Present Value Of Project Research Articles

Firm Growth and Disclosure: An Empirical Analysis

AbstractExtant theoretical research posits that information asymmetry and agency issues affect the cost of external financing and hence impact the ability of firms to finance their growth opportunities. In contrast, the literature on disclosure policy posits that expanded and credible disclosure lowers the cost of external financing and improves a firm's ability to pursue potentially profitable projects. An empirical implication is that disclosure can help firms grow by relaxing external financing constraints, thereby allowing capital to flow to positive net present value projects. This paper empirically evaluates this prediction using firm-level data over an 11-year period. As anticipated by theory, we find a positive relation between firm disclosure policy and the externally financed growth rate, after controlling for other influences.

Mining cutoff grade strategy to optimise NPV based on multiyear GRG iterative factor

One of the most difficult problems in a mining operation is how to determine the optimum minable cutoff grade over the lifespan of the mine that will maximise the operation net present value (NPV). Maximising the NPV in a mining operation, subject to different constraints, is a non-linear programming problem. Cutoff grade optimisation is used to determine the operating mining strategy that will maximise the total profit value of the mine. Constrained by the production capacity of the mill, and by sacrificing the mining low grade material, this approach enables the mill to process ore that delivers an improved time discounted cashflow. The cutoff grade policy calculated from the algorithm introduced in this paper has a significant influence on the overall economics of the mining operation. This paper describes the process to determine the cutoff grade strategy used in a mining operation based on Lane's algorithm using an optimisation factor which is iteratively calculated for every production year which dynamically adjusts the remaining reserves and thus the total life of the mine to maximise the project NPV. The introduced algorithm is an adaptation from Lane's algorithm that incorporates an iterative routine used to calculate the optimisation factor embedded in the cutoff grade equation. The algorithm was developed at Virginia Tech and runs using a windows visual basic program linked to a spreadsheet interface. The benefits of the methodology are demonstrated using a hypothetical case study. The authors have observed an improvement of the total NPV using the general reduced gradient (GRG) approach to iteratively calculate the optimisation factor for every production year.

CAPM-Based Valuation of Financial Government Supports to Infeasible and Risky Private Infrastructure Projects

Driven by acute fiscal problems and disenchantment with the performance of publicly delivered quality services, many governments in both industrial and developing countries are now relying on the private sector to deliver infrastructure services. In the context of private infrastructure financing, the provision of governmental support is not uncommon. The present paper discusses the theoretical framework of the valuation of the financial impact of support on the cost of debt, cost of equity, the expected return on equity (ROE), and the project's net present value (NPV), based on the capital asset pricing model (CAPM) within a single-period context. Special focus is placed on a minimum revenue guarantee, a direct cash subsidy, and a subsidized subordinated debt. This paper shows that a guarantee reduces the cost of debt and can increase or decrease the cost of equity depending on the leverage, while a subsidy increases only the cost of equity. A subsidized subordinated debt increases both the cost of senior debt and the cost of equity. For all cases, all the supports improve the NPV because the expected increase of ROE can more than sufficiently offset any change in the cost of equity. This paper is of interest to academics because it provides the theoretical analysis of how a support can affect the rates of return expected by debt and private equity investors from risky and, probably, infeasible privately financed infrastructure projects. Practitioners, particularly those from the public sector, can also benefit from research findings that may inform decision makers about what support to provide.

Do a firm's equity returns reflect the risk of its pension plan?

This paper examines the empirical question of whether systematic equity risk of US firms as measured by beta from the capital asset pricing model reflects the risk of their pension plans. There are a number of reasons to suspect that it might not. Chief among them is the opaque set of accounting rules used to report pension assets, liabilities, and expenses. Pension plan assets and liabilities are off-balance sheet and are often viewed as segregated from the rest of the firm, with its own trustees. Pension accounting rules are complicated. Furthermore, the role of the Pension Benefit Guaranty Corporation clouds the real relation between pension plan risk and firm equity risk. The empirical findings in this paper are consistent with the hypothesis that equity risk does reflect the risk of the firm's pension plan despite arcane accounting rules for pensions. This finding is consistent with informational efficiency of the capital markets. It also has implications for corporate finance practice in the determination of the cost of capital for capital budgeting. Standard procedure uses de-leveraged equity return betas to infer the cost of capital for operating assets. But the de-leveraged betas are not adjusted for the risk of the pension assets and liabilities. Failure to make this adjustment typically biases upward estimates of the discount rate for capital budgeting. The magnitude of the bias is shown here to be large for a number of well-known US companies. This bias can result in positive net present value projects being rejected.

AN ANT COLONY ALGORITHM FOR IMPROVING THE NET PRESENT VALUES OF RESOURCE CONSTRAINED PROJECTS

ABSTRACT An ant colony algorithm is proposed to improve the net present values of resource-constrained projects since the net present value is a critical criterion for a project with a long time span and considerable cash flows. The algorithm adaptively adjusts the allocation of scarce resources according to the pheromone generated by artificial ants in the previous iterations so as to maximize the project's net present value. The crossover operation, inverse mutation and elitist strategy are applied to accelerate the searching for better project schedules, and the backward scheduling technique is adopted to improve the net present value further. The experimental test results show that the proposed algorithm significantly improves the net present values of resource-constrained projects.

When does single‐source versus multiple‐source lending matter?

PurposeSeek to compare the consequences of single‐source versus multiple‐source lending for a borrower who has loans that can be prematurely terminated.Design/methodology/approachThe considered model framework is an option‐theoretic firm value model similar to Merton (1974) but where lenders have the additional right to prematurely terminate the loans. The single lender is a monopolist, while multiple lenders are represented by a continuum without individual impact on the aggregate termination decision.FindingsThe model explains that, if the borrower is in financial distress but has positive net present value projects, a single lender has a higher incentive to save the firm and therefore terminates fewer loans than multiple lenders. In the opposite case where the firm is not under financial distress, it is the other way round and multiple lenders terminate fewer loans than a single lender. As a result, equity holders are better off by having a loan from a single‐source under financial distress but multiple‐source lending is advantageous in the absence of financial distress.Research limitations/implicationsTo focus on the origin for arising differences from single‐source and multiple‐source lending, consideration is given to the simple case with perfect information and without monitoring and renegotiation. These market imperfections can be incorporated into the model in a straightforward way.Originality/valueWhile other models in the literature require market imperfections to explain the relevance of the bank relationship, this paper indicates that even in the absence of market imperfections the lending relationship is fundamental as long as lenders have the right for early terminations.

Subsea HIPPS: A Way To Develop High-Pressure Subsea Fields

Summary One of the challenges for the development of high-pressure oil and gas prospects in ultradeep water is the high capital-expenditure (CAPEX) cost of subsea flowlines and risers. Installing a high integrity pressure protection system (HIPPS) in the subsea system allows the flowline to be designed to just above well flowing pressure instead of well shut-in pressure. On the basis of flow simulations, pipeline design, and economic analysis, this paper demonstrates that installing subsea HIPPS results in the following: Lower installed cost of flowlines and risers. Early payback with incrementally higher flow of oil and gas. Secondary benefits including higher flowing wellhead and flowline temperatures. Another important benefit of using subsea HIPPS is that the weight of the risers hanging off at the host facility can be reduced substantially. Otherwise, heavy-walled risers may restrict the tie-in of the deepwater prospect to host facilities. With pressure decline over time, the thick-walled flowlines become overkill and tend to restrict the well flow rate. With subsea HIPPS, the larger flow area in the subsea flowlines will allow the field to be abandoned at a lower reservoir pressure. This means that that the total recoverable reserves from the field can be increased. The major finding of this paper is that for high-pressure reservoirs in ultradeep water, installing HIPPS subsea accelerates cash flow and increases the project net present value. These benefits will be illustrated on the basis of the analysis of a deepwater field-development design case.

Finance for practicing radiologists

This article reviews basic finance for radiologists. Using the example of a hypothetical outpatient computed tomography center, readers are introduced to the concept of net present value. This concept refers to the current real value of anticipated income in the future, realizing that revenue in the future has less value than it does today. Positive net present value projects add wealth to a practice and should be pursued. The article details how costs and revenues for a hypothetical outpatient computed tomography center are determined and elucidates the difference between fixed costs and variable costs. The article provides readers with the steps used to calculate the break-even volume for an outpatient computed tomography center given situation-specific assumptions regarding staff, equipment lease rates, rent, and third-party payer mix.

Accounting Conservatism and the Relation Between Returns and Accounting Data

This study adds change in cash investments and change in lagged operating assets to the regression of returns on earnings levels and earnings changes examined in Easton and Harris (1991). We argue that a positive coefficient on change in cash investments captures conservatism associated with investments in positive net present value projects the effects of which will not flow into the accounting statements until the expected future benefits are realized. A positive coefficient on change in lagged operating assets implies accounting conservatism associated with the application of accounting rules to operating assets in place. Our empirical results are, in general, consistent with these arguments. We examine differences in conservatism across samples with different market to book ratios, we compare firms with non-negative returns with firms with negative returns, we compare firms reporting losses with firms reporting profits, and we examine firms in different industries, firms with different levels of research and development expenditure, different amounts of depreciation, different amounts of advertising expense, and firms that adopt LIFO inventory valuation compared with those that adopt an alternative to LIFO.

Do a Firm's Equity Returns Reflect the Risk of Its Pension Plan?

This paper examines the empirical question of whether systematic equity risk of US firms as measured by beta from the capital asset pricing model reflects the risk of their pension plans. There are a number of reasons to suspect that it might not. Chief among them is the opaque set of accounting rules used to report pension assets, liabilities, and expenses. Pension plan assets and liabilities are off-balance sheet and are often viewed as segregated from the rest of the firm, with its own trustees. Pension accounting rules are complicated. Furthermore, the role of the Pension Benefit Guaranty Corporation clouds the real relation between pension plan risk and firm equity risk. The empirical findings in this paper are consistent with the hypothesis that equity risk does reflect the risk of the firm's pension plan despite arcane accounting rules for pensions. This finding is consistent with informational efficiency of the capital markets. It also has implications for corporate finance practice in the determination of the cost of capital for capital budgeting. Standard procedure uses de-leveraged equity return betas to infer the cost of capital for operating assets. But the de-leveraged betas are not adjusted for the risk of the pension assets and liabilities. Failure to make this adjustment typically biases upward estimates of the discount rate for capital budgeting. The magnitude of the bias is shown here to be large for a number of well-known US companies. This bias can result in positive net present value projects being rejected.

Positive hurdle rates without asymmetric information

We present a simple model where a firm will commit to a strictly positive hurdle rate on investment proposals by managers even though the two parties are symmetrically informed about the investments' profitability. Facing a positive hurdle rate, a manager who derives partial benefits from the investment profits will have more incentive to collect information about the projects. The optimal hurdle rate trades off the benefit of more information with the cost of foregoing ex post positive Net Present Value (NPV) projects.

The incremental funding method: data-driven software development

Software development projects don't get funded unless they return clearly defined value to the business. Demands for shorter investment periods, faster time-to-market, and increased agility require new, radical software development approaches. These approaches must draw on the expertise of both software architects and financial stakeholders and open the traditional black box of software development to rigorous financial analysis. We can accomplish this only by positioning software development as a value-creation activity in which business analysis is integral. The incremental funding method is a financially informed approach to software development. IFM maximizes returns by delivering functionality in "chunks" of customer-valued features, carefully sequenced to optimize the project's net present value (NPV). We derived the IFM concepts from several years' experience in winning competitive contracts for large-systems integration and application development projects.

RANKING MUTUALLY EXCLUSIVE PROJECTS: THE ROLE OF DURATION

This paper develops a new measure of cash-flow timing called “return duration.” Numerically quite close to Macaulay duration, return duration is a straightforward function of a project's net present value (NPV) and internal rate of return (IRR). When comparing mutually exclusive projects, differences in return duration can explain ranking conflicts between NPV and IRR. The paper also clarifies the conditions under which a manager should consider duration or generalized NPV before making investment decisions when faced with such ranking conflicts.

Debtor-in-possession financing and bankruptcy resolution: Empirical evidence

Debtor-in-possession (DIP) financing is unique secured financing available to firms filing for Chapter 11. Opponents of DIP financing argue that it leads to overinvestment. Alternatively, DIP financing can allow funding for positive net present value projects that increase the likelihood of reorganization and reduce time in bankruptcy. Using a large sample of bankruptcy filings, we find little evidence of systematic overinvestment. DIP financed firms are more likely to emerge from Chapter 11 than non-DIP financed firms. DIP financed firms have a shorter reorganization period; they are quicker to emerge and also quicker to liquidate. The reorganization period is even shorter when prior lenders provide the DIP financing.

Consequences of Bank Distress During the Great Depression

The consequences of bank distress for the economy during the Depression remain an area of unresolved controversy. Since John M. Keynes (1931) and Irving Fisher (1933), macroeconomists have argued that bank distress magnified the extent of the economic decline during the Depression. As the intermediaries controlling money and credit, banks were in a special position to transmit their distress to other sectors. But the mechanism through which banking distress mattered for the economy has been hotly contested. Milton Friedman and Anna J. Schwartz (1963) saw the contraction in the money multiplier—driven, in their view, by panicked depositors’ withdrawals of deposits—as the primary mechanism through which banking distress affected the real economy. They described the mechanism transmitting banking distress to the real sector as operating at the national level through changes in the aggregate supply of money and interest rates. Bank distress reduced the money supply available to the public either through the closure of banks and the consequent freezing of bank deposits, or the withdrawals of deposits by depositors that feared bank failure. Ben S. Bernanke (1983), building on Fisher (1933), emphasized the transmission of monetary shocks via their effects on the balance sheets of borrowers and on the supply of credit by banks. Borrowers’ balance sheets were worsened by debt deflation as the result of fixed dollar debt obligations—borrowers’ net worth and cash flow declined with the rising value of debt service costs relative to income. Borrowers with positive net present value projects, but weak balance sheets, had less internally generated retained earnings to invest and could not qualify for credit. Furthermore, Bernanke argued that the contraction of the money supply produced contraction of nominal income and prices relative to fixed debt service, which weakened borrowers’ balance sheets, and in turn, weakened banks. Not only did firms’ financial distress reduce the number of qualified borrowers, the contraction in banks’ net worth forced a reduction in the supply of bank loans to qualified borrowers. Many firms and individuals relied on banks for credit, and as those banks suffered losses of capital (due to asset value declines) and contractions in deposits (as depositors reacted to bank weakness by withdrawing their funds), even borrowers with viable projects and strong balance sheets experienced a decrease in the effective supply of loanable funds. Bernanke termed the combined weakening of borrowers’ balance sheets and the contraction in bank credit supply a rise in the “cost of credit intermediation.” The scarcity of perfect substitutes for the positive net present value investments of firms with weak balance sheets, and for the credit supplied by existing banks, implies that the weakening of firms’ and banks’ balance sheets, the disappearance of banks, and the contraction in surviving banks’ lending made it more difficult for the economy to channel funds to their best use. Thus, what began as a contraction in aggregate demand became a contraction in aggregate supply, which magnified adverse economic shocks and prolonged and deepened the Depression. The financial distress of firms and banks, and the decline in bank lending, were not only symptoms of the Depression, but means for magnifying the shocks that caused the Depression. Bernanke’s statistical evidence in support of this story is derived from time-series analysis at the national level, in * Calomiris: Graduate School of Business, 601 Uris Hall, Columbia University, 3022 Broadway, New York, NY 10027, and National Bureau of Economic Research (e-mail: cc374@columbia.edu); Mason: Department of Finance, Drexel University, 3141 Chestnut Street, Philadelphia, PA 19104 (e-mail: joe.mason@drexel.edu). We thank Valerie Ramey, David Wheelock, Charles Himmelberg, Steve Zeldes, Gary Gorton, two referees, and seminar participants at Columbia University, Wharton, Northwestern University and the 2001 Economic History Association Meetings for helpful comments on an earlier draft. We gratefully acknowledge support from the National Science Foundation, the University of Illinois, and the Federal Reserve Bank of St. Louis.

How to use Stock and Stock Options for Interest Alignment: Managerial Investment Behavior and Portfolio Considerations

This paper analyzes theoretically the effect of stock and stock options on the investment behavior of managers. Recent theoretical results state that stock options are an inefficient means of motivating managerial effort. But if the manager holds restricted stock and is allowed to invest his non-firm related wealth in the market portfolio and the riskless asset, he will pass up positive net present value projects since he cannot diversify the firm-specific risk. The paper analyzes if and how this investment incentive problem can be mitigated by issuing stock options. In case options are used alternatively to stock, we find that for every positive exercise price lower than a critical level, there exists a unique number of options to induce the desired investment behavior if the manager does not hold any stock. The relation between exercise price and number of options issued is positive. Though, if the manager holds both stock and options, options with low exercise prices can no longer mitigate the underinvestment problem. In contrast, for exercise prices sufficiently large to eliminate the underinvestment incentives and a given number of stock, there are a small and a large number of options to induce the desired investment behavior. Since recent theoretical contributions have called into question the efficiency of stock options in motivating managerial effort compared to restricted stock, this paper can make a contribution concerning the prevalence of stock options in executive compensation. A numerical analysis completes the paper and underlines the relevance of the theoretical results.

Inflation and the Constant-Growth Valuation Model: A Clarification

We examine the effects of inflation on the standard, Constant-Growth valuation model found throughout the finance literature. We find that the presence of inflation vitiates the generally accepted expression of this model for the value of a firm that either makes no new investments or invests only in zero net present value projects. If expected inflation is positive, the generally accepted and widely used expression for the value of the firm under either of these two conditions seriously understates the true value of the firm, even at modest levels of inflation. For example, assuming zero net new investments, a real interest rate of 6% and a rate of inflation of 2%, the commonly accepted expression understates the true value of the firm by 25%. We also examine the effects of inflation on the firm's weighted-average cost of capital (WACC), which is an important parameter in the Constant-Growth model. We find that the popular WACC equation developed by Modigliani and Miller is not inflation-neutral when stated in nominal terms. Specifically, when expected inflation and corporate tax rates are positive, the nominal M&M WACC understates the firm's true nominal WACC by a non-trivial amount. We show how to adjust the standard M&M formula to correct for this understatement. In contrast to the M&M model, we find that the WACC equation developed by Miles & Ezzel is inflation-neutral when stated in nominal terms, and thus, there is no need to adjust the equation in the presence of positive expected inflation. We conclude the paper by documenting the widespread misapplication of the Constant-Growth model under conditions of inflation found throughout the finance literature and in the practical application of corporate valuation techniques.

A bidirectional heuristic for maximizing the net present value of large‐scale projects subject to limited resources

AbstractWe consider the scheduling of large‐scale projects to maximize the project net present value given temporal and resource constraints. The net present value objective emphasizes the financial aspects of project management. Temporal constraints between the start times of activities make it possible to handle practical problem assumptions. Scarce resources are an expression of rising cost. Since optimization techniques are not expedient to solve such problems and most heuristic methods known from literature cannot deal with general temporal constraints, we propose a new bidirectional priority‐rule based method. Scheduling activities with positive cash flows as early and activities with negative cash flows as late as possible results in a method which is completed by unscheduling techniques to cope with scarce resources. In a computational experiment, we compare the well‐known serial generation scheme where all activities are scheduled as early as possible with the proposed bidirectional approach. On the basis of a comprehensive data set known from literature containing instances with up to 1002 activities, the efficiency of the new approach is demonstrated. © 2003 Wiley Periodicals, Inc. Naval Research Logistics, 2003

Risk analysis in investment appraisal based on the Monte Carlo simulation technique by A. Hacura, M. Jadamus-Hacura and A. Kocot

Comment on Eur. Phys. J. B 20, 551 (2001) Since Hertz major work on investment appraisal using the Monte Carlo Simulation technique, the so called “Risk Analysis” has become a standard tool for supporting investment decisions [1,2]. A main problem in investment appraisal is to consider and specify the risk of investment projects in an appropriate way, for enabling consistent project evaluation. In calculating a risky project's net present value (NPV) the major difficulty is to quantify the project's risk for quantifying an appropriate risk adjusted discount rate (RADR). Theoretically not founded risk adjusted discount rates face a lot of critique. Furthermore it is discussed that the incorporation of a constant risk factor into the discount rate makes a certain assumption about the resolution of uncertainty over time [3] and finally that a single net present value could not in general reflect risk properly. Especially in consequence of the last point the proponents of simulation argue that a whole distribution of net present values shows a project's risk better than a single number. In the special issue “Econophysics” of this journal Hacura et al. tried to describe the methodology and use of Monte Carlo Simulation in investment appraisal [4]. The purpose of this comment is to point out three fundamental flaws in that article.

Project valuation when there are two cashflow streams

Some authors advocate the separate discounting of different cashflows when calculating net present value (NPV). However, some textbooks ( Principles of Corporate Finance, Financial Theory and Corporate Policy: 3rd ed.) focus on calculating NPV by discounting the expected net after tax cashflow using the weighted average cost of capital (WACC) as the discount rate. We show that discounting the expected net after tax cashflow of a project using the WACC yields an incorrect project NPV. A new method for calculating project NPV's using a separate cashflow discounting method is proposed and applied to calculating the NPV's of some North Sea oil projects.