4 Reasons Why Managers Can Accept Negative NPV Projects

Net Present Value (NPV) is negative when the present value of a project’s benefits is lower than the present value of its costs. Generally, a project is considered acceptable if its net present value is positive. Taking on a negative NPV investment will reduce the company’s value, as its benefits do not exceed its costs.

A manager can accept negative NPV projects due to the sunk cost fallacy, a high discount rate, to please shareholders in a company in financial distress, or because they prefer running a big firm over a smaller one.

Still confused? Keep reading for a more comprehensive explanation of why managers would accept negative NPV projects:

Understanding Net Present Value (NPV)

The net present value (NPV) of a project is equal to the present value of the benefits of the project minus the present value of its costs.

Any future project you evaluate will have expected cash flows. These are estimations for what you think the project will generate. However, to get the project up and running, you will likely have to make an initial investment too. On top of that, it’s likely there are costs during the life of the project to keep it going.

Therefore, the NPV of a project is the value of all its cash flows (positive and negative) in terms of cash today (present value).

You get to the present value (PV) of cash flows by discounting them with a rate that reflects their riskiness (usually the WACC). You do this because a dollar today is worth more than a dollar tomorrow.

A good project has a positive net present value (IRR > WACC). And when presented with different projects, you should pick the one with the highest NPV. If you accept those projects it is the equivalent of receiving their NPV in cash today—as long as you correctly captured all the costs and benefits.

A negative NPV project means you lose money and the company’s value drops along with the wealth of investors, as the costs of the project are bigger than its benefits. The present value index is below 1. This means you should reject the project.

Knowing this, why do some managers accept negative NPV projects?

Why Would Managers Accept Negative NPV Projects

Here are 4 reasons why managers would accept negative NPV projects:

1) Sunk Cost Fallacy

People sometimes continue to invest in a project that has a negative NPV because they already invested a large amount in the project and feel that by not continuing it, the previous investment is wasted.

This is wrong because if continuing a project gives you a negative NPV, you can create value by abandoning it, regardless of how much investment is already sunk into the project.

2) High Discounting Rate

The riskier the project, the smaller its NPV because you discount its cash flows at a higher rate to reflect that riskiness, which results in a smaller PV of the cash flows.

If the difference between benefits and costs is positive, but after applying the discount factor it gives a negative NPV, a manager that really believes in the project may go forward with it.

The manager believes even though the investment opportunity currently has a negative NPV, it does not imply it is worthless. As long as there is a chance that the investment opportunity could have a positive NPV in the future, the opportunity is worth something today, given the option to wait.

3) To Please Shareholders

A manager may try to launch one last hail-mary very risky project to please shareholders.

This usually happens when a company is in such a difficult financial situation that, if nothing is done, it will go bankrupt and shareholders will get nothing with 100% certainty.

Someone has to pay for the new project though. Who? Debtholders. Here’s how:

A company in financial distress likely has a low (or even negative) equity value, as the market doesn’t believe in it anymore. Thus, its debt is what finances most of its assets.

If this risky project doesn’t work and the firm loses value, the debt holders are the ones who suffer. They’re exploited. Why? Because the equity holders already have zero. The company could sell the assets it still has and pay back its lenders.

Instead, the manager takes the risk of further lowering the value of those assets in hopes shareholders get something instead of zero.

In other words, when a company is in financial distress, shareholders can gain from projects that increase the risk of the company, even if they have a negative NPV, because leverage gives shareholders an incentive to replace low-risk assets with riskier ones.

Value is transferred from the bondholders to the shareholders. This is often called the asset substitution problem.

4) Empire Building

Managers may have their own personal agenda.

They prefer to run large companies rather than small ones, because managers of large firms get higher salaries, have more prestige, and get greater publicity than managers of small firms.

As a result, they will take on investments that increase the size—rather than the profitability—of the company.