In our article "How to Know Whether
an Investment is Better or Worse than Another?" I explained how the Net
Present Value (NPV) method allows the
comparison of investment opportunities involving different amounts of money and
having different levels of risk.
Furthermore, in my last article ("Enjoy
the Cake without Eating It") it was concluded that the NPV method only worked in a developed
capital market that allows the purchase and sale of financial instruments with
full transparency and no barriers. Following, I will pose an example that
clarifies this last idea.
Panchito Eché is a citizen of one of the
few socialist "havens" remaining on the planet: the island of Cuba.
Panchito has been saving a little money from the clandestine sale of cigars to
the tourists. Following the recent measures adopted by the revolutionary
government (which have opened the door to certain capitalist activities)
Panchito is considering starting a small restaurant in Havana.
The business promises a yield of about
15%. However, to preserve the operating license it will be necessary to keep
government inspectors happy. This will require splitting profits with officials
reducing the final return to just 8 % annually.
Jason Ramirez, Panchito's cousin who lives
in Miami, told him that this type of business usually yields 12%. That is, when
buying shares of a chain of restaurants in the U.S. stockmarket you can expect a
yearly return of 12%.
Since Panchito´s restaurant will only yield
8%, its NPV would be negative and the
deal would have to be rejected. This is because it is much more convenient for
Panchito to invest money in shares of restaurants (with a similar risk) with a
yield of 12% than invest in the same business on his own.
Does this mean that Panchito should forget
about the deal?
To answer it the following question must
be asked: If he does not invest in the restaurant what could Panchito do with
his money (other than spend it)? Well,
because in Cuba there are no capital markets and Cubans are not allowed to
freely invest abroad, Panchito does not have the option to obtain a 12% yield
in restaurant stocks. This means that he have no choice but to hide his savings
under the mattress. But money under the mattress produces nothing. Therefore, if
he does not invest in the restaurant, Panchito´s best option is to
"invest" his money (under the mattress) at a zero percent yield.
Although the restaurant produces less than
it should for this type of business in Miami (and its NPV is negative) it is still better for Panchito to invest in the
restaurant since an 8% return is better than zero.
This example clarifies why the NPV method makes sense only if investors
have the opportunity to invest in shares listed on the capital markets that
have the same risk as the deal under consideration. In such markets it will
never be appropriate to accept negative NPV
projects because you can always get a zero NPV
by investing in the stockmarket. However, when access to capital markets is forbidden
negative NPV investments may be
acceptable.
Fortunately, with the exception of
"havens" such as Cuba, the rest of us have the opportunity to invest
in developed financial markets. Thus, the NPV
rule applies virtually everywhere.
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