NPV: What It Reveals About Investment Decisions
Two companies, identical in every way except their capital structure, must decide whether to accept a five-year investment. The project requires a $1M annual investment for five years, with a final-year revenue of $6.5M. We use Net Present Value (NPV) to help understand the decision.
- Company A is 90% debt-financed.
- Company B is 90% equity-financed.
- Cost of debt (both firms) = 8% per year.
- Cost of equity = 16% per year.
Using the weighted average cost of capital (WACC) formula:
- Company A’s WACC: 9%
- Company B’s WACC: 15%
Since NPV depends on WACC, Company A will discount future cash flows at a lower rate, making the project appear more attractive.
NPV Calculation: Should They Accept?
Using the respective discount rates:
- Company A’s NPV: +$0.34M (Accept) ✅
- Company B’s NPV: -$0.12M (Reject) ❌
Since the result positive for Company A, it should accept the project. But for Company B, the negative result suggests rejecting it.
Impact of Capital Structure on Decision Making
Since Company B’s WACC is higher, its discount rate erodes the present value of future cash flows, lowering its NPV. As a result:
- Company B must pursue riskier, high-return projects to generate positive net positive returns.
- Company A has more flexibility to accept moderate-return investments.
Because Company B requires a minimum 15% return to break even on NPV, it must price projects higher to compensate for its higher cost of capital. This can create problems:
- Projects may be seen as overpriced – making it harder to compete.
- Lower acceptance rates – businesses seeking funding may reject Company B’s offers.
- Fewer growth opportunities – if Company B consistently demands high returns, it may lose deals to competitors with lower capital costs.
Over time, Company B may find itself stuck in a cycle of chasing high-risk, high-reward investments, while Company A can steadily build value with more affordable project pricing.
The Hidden Risks of High Debt
While Company A benefits from a higher NPV, its 90% debt financing introduces risks:
- Cash Flow Sensitivity – High fixed debt payments make it vulnerable to downturns.
- Interest Rate Exposure – Future projects may have lower NPV if borrowing costs rise.
- Financial Rigidity – Too much debt limits flexibility in tough times.
Thus, NPV alone does not capture all risks—debt-heavy companies may suffer in volatile markets.
Conclusion: NPV Guides, But Risk Matters
This case highlights why NPV is a valuable decision-making tool, but also reveals the hidden dangers of extreme capital structures.
- Company A’s high debt load is risky. While its lower WACC allows it to accept more projects, its financial stability depends on consistent cash flow and low interest rates. A downturn or rising borrowing costs could jeopardise its entire business. Company A should consider refinancing with a specialist finance broker to secure more sustainable funding.
- Company B is limiting its growth potential. With 90% equity, its high WACC forces it to chase riskier investments and price projects aggressively, leading to missed opportunities. By recapitalising with lower-cost debt, Company B could reduce its WACC, improve NPV on future investments, and compete more effectively.
Both companies need to reassess their capital structure strategies to maximise their financial health and growth potential.
Need expert guidance on refinancing or restructuring? A skilled commercial finance broker can help businesses secure the right funding mix. Request a callback from Convergent Capital Corp to be connected with a top independent broker today.
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External Links to Consider
- Australian Bureau of Statistics: Business Indicators, Australia – Quarterly estimates of private sector sales, wages, profits and inventories December 2024
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Disclaimer:
The information provided in this article is for general guidance and informational purposes only. You should should seek professional advice and conduct thorough assessments specific to your circumstances before acting on any of the matters addressed. Financial products and regulations may change over time, so it is essential to stay updated and consult with experts specialising in finance.
The writer cannot be held liable for any actions or decisions based on the information provided. Readers should consult their legal, tax, or financial advisors to evaluate suitability and implications.
