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:

1. Cash Flow Sensitivity – High fixed debt payments make it vulnerable to downturns.
2. Interest Rate Exposure – Future projects may have lower NPV if borrowing costs rise.
3. 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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Relevant Articles from our Catalogue

1. Unlock Growth with Business Commercial Asset Finance
2. Finding the Right Balance: Debt vs. Equity Funding for Your Business

External Links to Consider

1. Australian Bureau of Statistics: Business Indicators, Australia – Quarterly estimates of private sector sales, wages, profits and inventories December 2024
2. Reserve Bank of Australia: Household and Business Finances in Australia

Disclaimer:
This comparison is a simplified example to illustrate the impact of capital structures on NPV and WACC. It should not be used as a basis for decision-making without a thorough examination of other critical factors, including your cost of equity, cost of debt, financial performance, and the nature of your balance sheet. Always consult with a financial advisor or expert before making strategic decisions.