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Consider the alternatives
2
Adjust the discount rate
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Use real options
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Evaluate the synergies
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Monitor and review
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Here’s what else to consider
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Capital budgeting is the process of evaluating and selecting long-term investments that align with your business goals and strategy. One of the most common tools for capital budgeting is net present value (NPV), which measures the difference between the present value of cash inflows and outflows of a project. A positive NPV means that the project is profitable and adds value to your firm, while a negative NPV means that the project is unprofitable and destroys value. However, not all projects can be judged solely by their NPV. Sometimes, you may encounter negative NPV projects that have strategic value for your firm, such as entering a new market, creating a competitive advantage, or enhancing your reputation. How do you deal with these projects? Here are some tips to help you make better capital budgeting decisions.
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- Ryan Merriam Senior Cybersecurity Supervision Manager - LFBO Technology Risk Supervision Program 4
1 Consider the alternatives
Before you reject a negative NPV project, you should consider the alternatives. What are the opportunity costs of not pursuing the project? What are the risks of losing market share, customer loyalty, or brand image? What are the potential benefits of waiting for a better project or investing in something else? You should compare the negative NPV project with the best alternative use of your funds, and see if the strategic value outweighs the financial loss.
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- Ryan Merriam Senior Cybersecurity Supervision Manager - LFBO Technology Risk Supervision Program
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My view is that many of these alternatives are able to be built into an NPV model through scenario analysis. Consider the following:- Adjusting your NPV model for potential loss of market share if an action is not taken. - Loss of sales due to brand damage because of a lack of spend -attrition in loyal customers and the cash flow impact due to not replacing dated systems While these items might be difficult to build into a model, engaging a cross functional team within your organization to ask difficult questions can help finance present effective NPV scenario analysis that resonates with executives.
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2 Adjust the discount rate
Another way to deal with negative NPV projects is to adjust the discount rate. The discount rate reflects the required rate of return on your investment, and it affects the present value of future cash flows. A higher discount rate means a lower present value, and vice versa. If you think that the discount rate is too high for a negative NPV project, you can lower it to reflect the strategic value of the project. For example, you can use a lower discount rate for projects that have a high growth potential, a strong competitive edge, or a positive social impact.
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3 Use real options
A third way to deal with negative NPV projects is to use real options. Real options are opportunities to modify or abandon a project in response to changing conditions or new information. For example, you can have the option to expand, contract, defer, or abandon a project depending on the market demand, the competitors' actions, or the technological innovations. Real options can increase the value of a project by reducing uncertainty, enhancing flexibility, and creating upside potential. You can use real options analysis to estimate the value of these options and add them to the NPV of the project.
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4 Evaluate the synergies
A fourth way to deal with negative NPV projects is to evaluate the synergies. Synergies are the benefits that arise from combining two or more projects or activities that create more value together than separately. For example, you can have synergies from economies of scale, cost savings, revenue enhancement, or resource utilization. Synergies can increase the NPV of a project by improving the cash flows, reducing the costs, or increasing the revenues. You can use synergy analysis to identify and quantify the sources and effects of synergies and add them to the NPV of the project.
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5 Monitor and review
A final way to deal with negative NPV projects is to monitor and review them regularly. You should track the performance and progress of the project, and compare it with the expected outcomes and assumptions. You should also update the NPV calculation with the latest data and information, and adjust the discount rate, the real options, and the synergies as needed. You should also be ready to make changes or terminate the project if it does not deliver the strategic value or if it becomes too risky or costly.
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6 Here’s what else to consider
This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?
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