Debt And Equity Consideration

Published Date: 02 Nov 2017

Debt and equity consideration 2

Difficulty of raising fund locally 3

Debts 3

Equity 3

Exchange risk 3

Transaction exposure 4

Economic exposure 4

Translation exposure 4

Benefits of raising capital locally 4

Opportunity and Risk of proposal for expansion 5

Question 2: 7

Country Risk 7

Country Risk Analysis 7

Economic performance: 7

Political concern 8

Financial factor 9

Country Credit Rating 9

Conclusion 10

Question 3 11

Political component 11

Politic condition 11

Country relation 12

Environment 12

Conclusion 12

Economic performance 12

Conclusion 15

Financial factor 15

Conclusion 16

Conclusion 16

Question 4 17

Company 17

Cost of Capital 17

CAPM 17

Advantage of CAPM 18

Disadvantage of CAPM 18

NPV technique 18

Disadvantage of NPV 19

Reference 21

Question 1:

Raise capital locally

What does it mean by "raising capital locally"? It is the strategy in order to raise capital in the country where they operate. For example, Morrison based in Bradford can operate the Leeds brand which was financed in Leeds. [1] The most common way to raise fund locally is by borrow from local financial source.

Pormind Ltd try to raise money in foreign country rather than using capital fund from the UK. They need to consider what should be chosen debt or equity, the limitation of raising capital from other country.

Debt and equity consideration

Debt financing is in form of loan or debenture which will need to be repaid in the agreed time at promised interest. Business can borrow for short-term or long-term depend on the situation. The main source can be bank, finance society and government. Debt has advantage of taxes deductible.

Moreover, the lender has no control over the business. Unlike issuing share the company has to give part of the authority to new shareholders leading to lowering the power of existing shareholders, debt finance giving company the freedom of control since lender only have ability to claim interest.

However, it is difficult to obtain a lot of debt finance for small firm. The company will be rated by the bank for the ability to pay back. The small company have low rating therefore, are allow for less debt in the company.

In addition, the more debt company has, the more risk associate with business. As the debt increase, the risk of default increase as the company may not have ability to pay back leads to disruption of business. As the results, the shareholders will require higher return for the same amount of investment.

On the other hand, Equity is investment from shareholder in exchange for ownership of the business. The main aim of shareholder is not repayment of money but the profit from investment. The fund can be obtained from investors, venture firm or existing owner.

It has advantage of no obligation to payback. Since the company has the right to not pay dividends, the share issue will reduce the risk of default

Furthermore, the share issue can increase the available fund without raising any debt help company increase the credit rating. Therefore, the company can strengthen their position to borrow more in the future. However, using equity finance will make existing owner lose their power of control.

Difficulty of raising fund locally

Debts [2] 

First of all, the company may face the problem of difficulty in borrowing.The reason may be from the local condition; the countries they try to raise money from may suffer from financial crisis or economics distress lead to low in supply of money. Therefore, it is difficult for not only overseas business to borrow money but also for local business. In order to raise capital locally, the business need to research about the country condition.

Moreover, the business also has to face higher cost due to the countries risk since it is overseas operation. The additional cost will be added onto the current cost of business. Consequently, it will increase the risk of business failure lead to an increase in rate of borrowing. In other words, the cost of raising capital locally will increase since the risk is higher for international business than domestic.

The higher debt the company acquired, the higher risk of bankruptcy they will face. Since the company need large amount of fund to start up the overseas operation, it will increase the level of debt to business leads to an unbalance in source of finance in the business. As the results of it the gearing ratios increase makes the company credit rate fallen which may affect current creditors. Subsequently, the business facing high risk of bankruptcy.

Furthermore, the effect of having more debts will increase the interest rate since the risk is higher, then, the creditors expect higher return. In other words, existing lender will increase their expected return in exchange for increase in risk.

Equity

Raising equity locally means the control power of existing shareholders will be less since the number of share increase. Besides, the equity raising locally means the UK shareholder may not buy to retain their power, therefore, it will lower the interest of existing shareholder in the business.

Since their share proportion reduced by that raising, the existing shareholders require higher return or share bonus. Consequently, the value of share will fall and the cost of capital will increase.

Moreover, the overseas share issues may cost firms more than issuing in the UK since the value may vary due to exchange rate as well as the marketing for the campaign.

Exchange risk

Exchange risk [3] is a financial risk which expose to the change of one currency to the other currency. There are 3 types of exposure in exchange risk :

Transaction exposure

The transaction exposure occurs in the foreign transaction when the exchange rate change between the date of contract and the actual received. In order to realize the value, company need to exchange to the functional currency, therefore, the fluctuated in exchange rate leads to a risk of exchange. [4] 5

In generally firms are exposed to direct result of activities such as borrowing and investing. [6] 

Economic exposure

Economic exposure is the risk of the market value being influenced by unexpected exchange rate fluctuations. Economic exposure can affect the present value of future cash flows. Any transaction that exposes the firm to foreign exchange risk also exposes the firm economically, but economic exposure can be caused by other business activities and investments which may not be mere international transactions. A shift in exchange rates that influences the demand for a good in some country would also be an economic exposure for a firm that sells that good. [7] 

Translation exposure

Translation exposure related to financial reporting which is affected by exchange rate movements. Organisation operate in multination must prepare consolidated financial statements for reporting purposes, the process of translating foreign assets and liabilities or the financial statements of foreign subsidiaries from foreign to domestic currency will be affected by the exchange rate. The risk will not affect the cashflow of business but the value of business as well as the interest of investors. (Bruce 2011)

Benefits of raising capital locally

Firstly, raising capital locally can reduce the cost of exchange compare to raising money nationally. The reason is if the company raising capital in the UK, the fund will be transferred to foreign countries branches and will be translate at the date of transaction. It may be at unfavourable rate due to the transaction risk.

Secondly, if the firm choose to use UK capital to fund the project, the fund will be translate from pound sterling into local currency then the profit will need to be translate again at the year ended for financial purpose. Hence, the value of business may fallen due to the different in exchange rate. By using local capital, business can reduce risk of translation affect the firm's value and also attract investors.

Moreover, raising capital locally may including joint-venture strategy, which can take advantage of local knowledge. It can help reducing the issues of legislation for foreign investment.

Last but not least, issuing share in foreign business can reduce the risk of nationalisation. Since in the UK there are several companies has been nationalised after the financial crisis, [8] with raising capital in foreign countries, the chance of being bought by government will be lowered.

Opportunity and Risk of proposal for expansion

Pormind plc suffered three years of loss following the Global Financial Crisis of 2008 and is seeing many of its traditional customers seeking supplies from new growing markets. It is the threat to the business since their customers are leaving. There are 2 possible choice they can make either strengthen business competitive advantage to attract customers or seeking for new customers.

As the company choose to seek for new customer overseas, the proposal of raising money locally can help the company to reduce the risk of exchange rate. There will be less transaction and translation risk of the company since the business operate using local capital as well as dealing with local customers.

Moreover, the venture business can share the risk of investment with the local business makes the operation more stable. The cost of capital will be less than using fund raised from the UK.

Furthermore, the business can take advantage of partnership to gain local knowledge such as customer behaviour, choice and target market. In addition, they can gain opportunity from overseas knowledge, products and services. It will help them build up stable competitive advantage for the business in local nation.

On the other hand, there are the problem occurs to Pormind since they have suffered 3 years of loss therefore, their credit rating will be low due to low interest cover. Consequently, investors may find the lending in Pormind may not worth it.

Moreover, the loss makes the value of its share fallen, therefore, it is difficult to find partners or new shareholders in the local business. In other words, they face the risk of failure in finding investors.

As the company may seek for joint venture, there will be the risk of control since the existing shareholder will lose their power. In addition, the company also may lose it control over the branches as they may hold part of the share in new venture.

Besides, as Pormind ltd has issues with loss as well as cashflow, their abilities to pay will be lowered therefore, the risk of increasing in cost of capital will be high. They may have to pay for higher interest for loans or high dividends for shareholders.

In conclusion, as Pormind, they are new to the foreign market means that the risk of failure in the international market will be high. As the company stretch out their hand to obtain new customers there are several analysis needed to be consider such as countries risk, business risk and internal valuation.

Question 2:

Country Risk

"Country risk in general refers to the risk associated with those factors that determine or affect the ability and willingness of a sovereign state or borrower from a particular country to fulfill their obligations towards one or more foreign lenders and / or investors" [9] 

Business transactions always involve risk of all level. When business operate internationally, there are additional risks which is not presented in domestic. Those risks are called country risks which affected by arising from a variety of national differences in economic structures, policies, socio-political institutions, geography, and currencies. [10] 

Country Risk Analysis

Country risk analysis (CRA) is used to identify the affect of country risk onto the risk of an expected return from overseas investment. There are multiple factors which need to be considered such as economics, politics, sociology and currency and so on. From number of analysis it can be seen that there are different important measures of country risk: The political risk, the economic risk, financial risk and country credit ratings.

Economic performance:

Economic risk is about significant change in the economic structure or growth rate affected the expected return of an investment. Economic risk consist of the risk from changes in fundamental economic policy goals such as fiscal, monetary, international, or wealth distribution or a change in a country’s comparative advantage for example resource limited, industry decline, demographic shift and so on.

From 2008, the financial crisis left with massive damage and it is hard for Europe to recover. [11] The after-effect remain with high unemployment, low economic growth, high inflation and low liquidity. The problem makes any business who want to invest in Europe considered.

Besides, from the work of Reddy (2011) using Beta Country Risk Model the study shows that the variation in country risk of India is highly correlated with changes in FDI flows, monetary policy, exchange rates and the unemployment rate which are all component of the economics risk. [12] 

The economic performance can show the fiscal irresponsibility. Using the government deficit as example the UK has high government deficit [13] as they are unlikely to provide the service they promises to people using existing resources. As the results, they resort to :

Expropriation of property: Capital flight and dry up new investments.

Raising taxes: affect incentive to work, save and take risks

Printing money: monetary instability, high inflation, high interest rates and currency depreciation

It creates the problem for business when they enter the market. High taxes will demotivate business investing; high inflation, high interest rate and currency depreciation creates uncertainty in transaction and high risk of exchange rates.

Economic Risk Measures: Analysts examine traditional measures of fiscal and monetary policy. For longer term investments, they also examine growth theory factors. For fiscal policy, analysts examine such factors as the size and detail of government expenditures, tax policy, and the government’s debt.

Analysts examine the impact of monetary policy and financial maturity on economic growth. For longer term investments, analysts focus on long-run growth factors , the degree of openness of economy and institutional factors that might affect wealth creation.

Political concern

The government policy influence the working of the economy affect value of the firm. The political risk covers the internal and external conflicts, expropriation risk and traditional political analysis. It may come from the adverse effect of the politic such as labor law, regulatory restriction, requirement for production or investment. Risk assessment requires analysis of many factors, including the relationships of various groups in a country, the decision-making process in the government, and the history of the country.

Using Central African Republic as an example, it can be seen that the political problem between the government and the Rebel leads to an unstable environment. Besides that, government policy change non-uniformly driven people to unemployment, corruption and fear of instability. [14] 

Moreover, the politic risk can affect economics in someways such as budget deficit shows the government abilities to reach their promises, change in import/export legislation can affect the business investment. The frequent of the change bring risk to foreign firm when they investing in the country since it create the instability. [15] 

The political risk can be measured by Frequency of government changes, level of violence, number of armed insurrections, conflict with other states. The lower frequency of government changing policy, the more stable environment for business. The lower level of violence can creates the trust and stabilities in economics, it provide the safety of environment and stability for citizen to work. Conflict with other country can bring the disruption to the business such as Middle East, the continuous war in there makes the business hard to grow and survive. [16] 

Financial factor

The financial factor is involving financial problem such as credit risk, liquidity risk, interest rate risk and so on. It reflect the risk to the business environment including the ability to payback for investment, the sustainable of the longterm business as well as the potential opportunity in the market.

The financial risk reflect the micro-environment of the country which related to the business. The financial risk is applied differently to the business. The most common factors considered are debt indicator, credit rating, access to bank finance and capital market.

This component is important to the country risk analysis since it shows the business the ability to gain from investment. The debt figure and the credit rating showing the level of trust can be put in that country. In other words, if the debt indicator is high and credit rating is low, it means that country has high risk of default as well as difficult to invest.

In addition, the financial factor including the level of fund can be access locally. The fund can be borrow from bank or venture capitalist or the company can raise from issuing share. It is important for business to know such thing since they may require some degree of local fund.

Country Credit Rating

Country credit rating present the level of risk of the investing environment in the country and is used for overseas investment. [17] 

Credit ratings are ranked by judgment and experience of the agencies to determine. It gives public and private the information to consider in a particular company or government. The credit rating can be used for individual or entities who want to invest in company or country.

The low credit rating means the country has high risk of default. The credit rating is based on the analysis of the past position as well as the economics and financial potential.

Conclusion

It can be seen that the politics risk, economics performance and financial are important in country risk analysis. It shows the affection of the environment to the business. If the investor want to invest in one country, he/she need to understand what is the political barrier, the risk of changing policy as well as the possibility of growth, the economics condition which may affect the project and the risk of finance involve.

Question 3

The country of choice is Costa Rica, the country in Central America, nearby Nicaragua, Panama, the Pacific Ocean, and the Caribbean Sea. [18] Based on the UNDP report, Costa Rica is among top country in American countries with high human development index. [19] 

Political component

Politic condition

Costa Rica's political stability, high standard of living, and well-developed social benefits system. Costa Rica has long emphasized the development of democracy and respect for human rights such as providing universal access to education, healthcare, clean water, sanitation, and electricity.

The country's political system has steadily developed, maintaining democratic institutions and an orderly, constitutional scheme for government succession. Several factors have contributed to this trend, including enlightened leadership, comparative prosperity, flexible class lines, educational opportunities that have created a stable middle class, and high social indicators. Also, because Costa Rica has no armed forces, it has avoided military involvement in political affairs, unlike other countries in the region. [20] 

Costa Rica undergoing fiscal reform to support the development policy. The change is to boost revenue, through modified existing tax legislation and provide fund for security services and education. The development strategy of the country is also focused on improving the country’s infrastructure, reforming taxes, increase number of jobs and improve living standard.

Costa Rica is recorded as the country with high concern about environment and human rights and advocacy of peaceful settlement of disputes. Since Costa Rica do not have military, it budget can be spent on providing services and supporting people. It would create the benefits for business to enter.

Costa Rica has been a strong proponent of regional arms limitation agreements. Therefore, the safety in the country regarding weapon can be assure. It can provide safe and stable environment

On the other hand, the Costa Rican legal environment remains cumbersome and inefficient, even though compare to regional neighbors Costa Rica is not inferior. The legal system is under reform therefore, it creates overlap as well as loophole.

The financial crisis makes the government spending has increased leads to a falling back into deficit. The tax reformation is to prevent this issues.

Country relation

Costa Rica is an active member of the United Nations and the Organization of American States. It provide the country with the strong link to international economic opportunity.

From 2007 to 2009, Costa Rica start diplomatic with China, "The State of Palestine," and reopen relationship with Cuba. The governance diplomatic of Costa Rica create the opportunity for the country economy to growth and expand for the foreign business. Besides, the diplomatic of Costa Rica with UN, China, Cuba and several country would also bring the challenge from the interactive of business among countries.

In 2011, Costa Rica has dispute concern the border issue with Nicaragua. It is the long procedure process which may damage the relationship between 2 countries. The problem creates the longterm conflict which may affect the economy.

Environment

Costa Rica is the country concern about the environment. From 1990s, Costa Rica become the environment protection country with success in sustainable development policies. [21] There are law and legislation prevent the pollution therefore, the manufacture may have restriction of production in Costa Rica.

Conclusion

From the analysis it can be seen that the politic risk is moderate since Costa Rica has the potential growth and stable politic. Even though, the legislation and taxation are under reformation, the risk of changing policy may be high, the impact on business is not high.

Economic performance

ECONOMIC [22] 

GDP (2010)

USD 35.39 billion

GNI per capita PPP (2009)

USD 10,930

FDI inflow (till 2010 Q3)

USD 1,015.5 million

Inflation (December 2010)

4.84%

Central bank assets (2009)

USD 4677.60 million (+7.88%)

Unemployment rate (2010)

7.3%

Government deficit (2010)

USD 1,869.73 million

Tax revenue (2010)

USD 4664.74 million (+9.65%)

Costa Rica enjoy stable economics growth disregard of the financial crisis. Costa Rica is wellknown for producing banana and coffee bean. The economic of Costa Rica not only depend on the agriculture but also manufacturing and industry. Manufacturing and industry contribute more than half of GDP in the 1990s, which is invested from overseas into Costa Rica. [23] The FDI inflow is high as the economy become stable and recover after financial crisis. The products and services has been broadened to high value such as technology.

Source: World Bank [24] 

From the chart information, it can be seen that the real GDP is fluctuated due to the problem of financial crisis. After experiencing positive growth over the previous several years, the Costa Rican economy shrank slightly in 2009 approximately -1.5% due to the global economic crisis. However, it is starting to recover and maintain at 4-5% growth. The inflation is stablized along with the GDP around 4-5% after the drop to 4.8% in 2011 from 13.5% in 2008.

The country use 99% of renewal energy resources and aim for carbon neutral in 2021. The country have build several facilities to produce sufficient level of electricity for internal use and have the potential to become green energy exporter.

The unemployment rate of Costa Rica is low 6.5% (2011) with 24.8% (2011) people are living in poverty. In comparison of Gini index, the living condition can be ranked 21st place. [25] Moreover, the government policy concentrated on human development leads to high educated workforce. The government budget has deficit of 4.4% of the GDP due to high spending for education. The highly skilled workforce can create the opportunity for country to develop in the future. On the other hand, an increase in high educated worker leads to lack of basic workers. It will create the shortage of job for highly skilled employees as well as increase the competitiveness of job seeking.

In addition, the new trade with China and some other countries can potentially boost the export to Asia in 2013. However, as the country become more open, the business expose to transnational issues such as new entry, highly competitive market and high transaction cost.

Conclusion

The economy has stable growth of 4-5% as well as low inflation after financial crisis which can benefits business investing. Moreover, Costa Rica has successful policy to attract foreign investors through tax incentive and highly skilled workforce. However, the open trade agreement with Asia bring to them high risk of competition as well as financial risk. To sum up, the economy performance is high and low economic risk.

Financial factor

The financial of Costa Rica is depend on US investment more than half of the investment come from US. [26] Therefore, there is risk of dollarization since the dollar inflow to the country. It caused by the domination of the capital investment from US as well as the attractiveness of stable Dollar.

Moreover, financial sector in Costa Rica is centered on the traditional banking system leads to less efficient and makes capital market become narrow and most investment is on public securities which has low risk. It makes the capital market less attractive as well as lack of incentive.

In addition, the countries monetary system is vulnerable against shock. The current monetary mechanism used in Costa Rica is interest rate to control the exchange rate. During economy downturn, the interest rate is high creates the adverse effect on the borrower. Country may face high interest rate risk.

Moreover, the large holding of US$ makes the bank expose to the liquidity risk. The holding of US$ due to the reservation as well as an increase in US investment makes it harder to deal with liquidity risk.

Besides, credit risk may rise due to global finance crisis. The large amount of foreign fund invest in the country makes the financial system vulnerable to the change in global finance.

Nevertheless, banking system become more diversified than before since there is more and more private bank enter the market. The increase in competitive with private bank, make the financial system more diversified.

The credit growth of the country has increase due to foreign fund buffer. The country is on the growing trend with stable economy and politic condition attract investment from overseas. The investment buff the necessary fund to the countries for development which creates higher credit rate for the country.

Conclusion

The financial system of Costa Rica has high level of risk which may affect the overall risk of the country. The reason is financial risk is the factor affect business directly. However, the country is under reform to improve the system for better.

Conclusion

Costa Rica has moderate political risk and low economic risk with high performance. The political and economics stabilities is created from the government policy of development.

The country benefit from high level of education and free trade zone create the sustain environment for business to enter.

On the other hand, the legal uncertainty of overlapping and conflicting responsibilities between agencies, difficulty of enforcing contracts, and weak investor protection due to the reform of legislation.

In overall, the risk analysis shows that the risk of Costa Rica is moderate with high potential of growth after reform.

Question 4

Company

Using Ocado Group as an example of using CAPM to calculate the cost of equity. Ocado is the company specialise in retailing food and products. Their service including taking order online and deliver order by specialist team. [27] 

Cost of Capital

The cost of capital is the cost of a company's funds which company required to return. The capital including debts and equity. There are several way to calculate the cost of capital, the most common way is Capital Asset Pricing Model which based on the relevant risk coefficient and the capital structure.

CAPM

The average β of the food retail industry is 0.68

The average Debt/ Equity ratios is 35% [28] 

As announced in the March 2012 Budget, the standard rate of corporation tax in the UK changed from 26% to 24% with effect from 1 April 2012 rather than the planned 25% which was enacted by the Finance Act 2011. Accordingly, the effective rate for the period is 24.67%. [29] 

Assume that the corporation debt is risk free.

Degear:

Βu = βe(Ve/(Ve+Vd(1-t)) = 0.68 *0.8 = 0.63

35% Ve = Vd => (Ve/(Ve+Vd(1-t)) = 0.9

Regear:

Βu = βe(Ve/(Ve+Vd(1-t))

Ocado debt/equity ratios: Debt = £31,150,000

Equity = £171,789,000

(Ve/(Ve+Vd(1-t)) = 0.88

Βu = βe(Ve/(Ve+Vd(1-t)) => 0.63 = 0.88 * βe

=> βe = 0.72

CAPM:

Ke = rm + (rm-rf)βe = 2% + (13%-2%)*0.72 = 9.92%

WACC:

WACC = Ke * (Ve/(Ve+Vd(1-t)) + Kd* (Vd(1-t)/(Ve+Vd(1-t)) = 8.97

Advantage of CAPM

The formula for CAPM is presented as a linear coefficient between the return required on an investment, such as a stock, and its systematic risk. It is easy to use for an estimation of cost of capital.

Since the CAPM was first developed by William Sharpe and his associates, CAPM has been tested, critiqued and tested again empirically by researchers using proxies for the different variables.

Weighted average cost of capital (WACC) is another investment analysis tool that can be used as a discount rate when appraising investments, with its own assumption that the investment project does not change either the business risk or the financial risk of the investing organisation. When WACC is relied on as the discount rate (rather than CAPM), it can lead to an incorrect investment decision in that a project may be rejected because its Internal Rate of Return, or measure of the worth of an investment, is less than that of the WACC.

Disadvantage of CAPM

Investment appraisal is premised on a long-term time horizon, whereas CAPM assumes a single-period time horizon, i.e. a holding period of one year, that could be taken to be constant over longer periods

Moreover, most individual investors are not able to borrow at the risk-free rate, and therefore the debt of the company in reality is not risk free. The assumption that the borrow rate is risk free rate will be incorrect and misleading. It can lead to incorrect decision.

The figure is estimation only using the market value and the risk free rate from country risk based. It may not be correct since the risk is differ from business to business, project to project, therefore, the CAPM may not be correct.

NPV technique

Net present value is the technique using the present value of future cashflow against the investment using the expected return. It is used to calculate expected return of the project using expected cashflow generate from project operation. (George & Goldberg 1995)

Advantages of NPV

NPV ( Net present value) helps company to make decision based on the estimation of cashflow. The calculation including the cashflow over the life span of the project shows the amount of cash holding. The company often analyse the profit but not cashflow which essential to the business since it shows the ability to pay for debt, dividends and operating activities. NPV based on cash will help company has clear view on liquidity and the ability to payback. (Khan 1993)

Besides, the value of money change every year due to inflation, money depreciation, interest payable, increase in expenditure and expected return. Using the time value of money to discount the amount of money company hold can shows better view. NPV shows how much money can be made in the future in today value.

The technique focus on the profitability and risk of the project. As the expenditure is included in cash outflow, to accept the project NPV need to be positive means the project is profitable. The discount factor based on the risk of return which the company expect to receive.

NPV technique is used to focus on maximizing the firm's value. The value of firm can be calculated by using the cash generate discount by the the business risk. It shows higher value of the firm than using the account figure of assets since it include the future prospective from sales.

Disadvantage of NPV

However, the NPV is difficult to use since it require the cashflow estimation as well as discounting value of money. It cannot be used for daily business activities but the project analysis.

Moreover, it is difficult to estimate the discount factor since the risk of the business is different with the project risk and there are several factor affect the risk such as economics, politic or financial element affect the business.

In addition, some people prefer percentage rate of return than the actual amount of cash. The reason is the NPV only shows the cash receive but not the profit while the investment is vary for project to project, therefore, it cannot be compare between different investment.

Besides, the cashflow is only estimation based on the past figure. Therefore, it may not be correct due to the change in the environment, business position as well as economic condition.

Issues not considered by the technique

Traditional way of calculating NPV is to use discounted cash flows. However, discounted cash flow approach to NPV rule does have its problems as well. According to Arya, Fellingham and Glover (1998), the basic NPV technique makes assumptions which are often overlooked. First, NPV ignore the project approval decision when choosing the project such as the option to do project after being turned down in the future and the option to defer, expand, abandon, modified or alternatively use of investment.

"Second, decisions are made either in a single person firm or in a multi-person in which there are no information asymmetries between the firm’s owners and managers (or between managers), and each member is motivated to the same objective." (Arnold, Hatzopoulos, 2000). In other words, NPV technique does not mention about managers' abilities to modified projects therefore firm may lose its' opportunity.

Moreover, NPV is an estimation of figure but not human since the method ignore the motivation of employees, relationship with manager and organisation operation as well as agency problem. There are several factor affect on the performance of the production which may differ from the calculation (Bachman 1966).

Besides, NPV does not specify when the firm cover the cost of investment which determine the risk of doing project. This problem can be assess by using payback method which cut off from the point where the project generate enough to cover the investment. However, the payback period ignore the cashflow after the recover period which may make NPV become negative. (Ross, Westerfield, Jordan, 2010)

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