Modified Net Present Value (MNPV): A New Technique for Capital Budgeting
In this paper we show that, when the firm’s opportunity rate of reinvestment is different from its financing rate, the risk-adjusted discount rate method (RADR) of computing Net Present Value (NPV) leads to the same type of incorrect results that required new methodology for modifying Internal Rate of Return (IRR) calculations (i.e. Modified Internal Rate of Return (MIRR)). Specifically, the current method of calculating NPV is biased in favour of (against) high-risk projects and against (in favour of) low-risk projects when the risk-adjusted discount rate is greater (less) than the firm’s average marginal cost of capital (WACC) for two reasons. First, it incorrectly assumes that the reinvestment rate for project cash inflows is the risk-adjusted discount rate of the project instead of the firm’s opportunity rate of reinvestment. Second, it incorrectly assumes that projected cash outflows, for the time periods after the initial outlay, are also discounted at the risk-adjusted discount rate. We propose a new methodology to establish a Modified NPV (MNPV) to eliminate the RADR methodology bias and derive a generalised rate of return (k*) under all combinations of reinvestment and financing rates for a firm. In addition we derive and demonstrate the linkages and consistency between the new MNPV, k*, Profitability Index (PI) and MIRR methodologies.
Volume (Year): 7 (2004)
Issue (Month): Special Conference Issue (December)
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