Am I correct in thinking that a project will have a lower npv if it sets up reserves and this is due to accelerating the emergence of losses? Also, for this to always be true is it important that the discount rate exceeds the rate at which reserves accumulate interest?
Yes, this is a good understanding. Higher reserves defers the emergence of profit. This will usually reduce the NPV because the Risk Discount Rate is lower than the interest rate earned on cashflows. If RDR = i then no effect on NPV If RDR < i then NPV will increase It will always be the first case in reality... If your business is pricing policies to earn less than the interest it receives on its prudent investments, the shareholders are a bunch of idiots. They should sell their shares and invest in the same prudent investments! However, there may be a CT5 question where RDR = i or RDR < i, perhaps to test whether you understand why the NPV reduces when we hold higher reserves? (which you do ;-) ) John
