Business
Net Present Value Method
Net Present Value (NPV) method is a financial technique used to evaluate the profitability of an investment by comparing the present value of expected cash inflows with the present value of cash outflows. A positive NPV indicates that the investment is expected to generate more value than it costs, making it an attractive opportunity for businesses.
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11 Key excerpts on "Net Present Value Method"
- Daniel Adrian Doss, William H. Sumrall III, Don W. Jones(Authors)
- 2017(Publication Date)
- Routledge(Publisher)
Some initiatives may require periods that are longer than those that are considered within this text. When these situations occur, it is recommended that NPV calculations be performed through the use of software spreadsheets, proprietary software, or financial calculators. Also, within the context of collegiate finance courses, a tabular solution is also available to solve NPV problems involving a variety of periods. However, for the purposes of this text, the use of the basic formula is appropriate to demonstrate the basic concept of net present value and to delineate the calculations through which NPV problems are solved. Future editions of this text, if any, are anticipated to contain the tabular solution methods of NPV problems.6.8 Chapter Comments and Summary
This chapter introduced the net present value (NPV) method of capital budgeting. The methods of capital budgeting encompass perspectives of time, cash value, rate, and profitability potential. The NPV is indicative of a cash perspective regarding the rendering of capital budgeting decisions. Further, the NPV method incorporates the time value of money within its primary construct. Derivation of the NPV method can occur through algebraic manipulation of the current monetary value formula given in Chapter 4 .The NPV method involves a consideration of the anticipated cash flows of a capital investment through time. These anticipated future values are discounted to determine their current monetary equivalencies. Conceptually, the NPV is the sum of the present monetary value of the anticipated future cash flows of a potential capital investment excluding the costs of investment. Therefore, the NPV method provides a cash-based perspective regarding capital budgeting initiatives. The NPV may be used as a solitary method of capital budgeting or may be used in conjunction with any (or all) of the capital budgeting methods described within this text. The NPV method may be used to examine single capital initiatives or multiple capital initiatives. Further, this method may be used with or without the constraints imposed by mutual exclusion conditions.
eBook - ePub- Brümmer LM, Hall JH, Du Toit E(Authors)
- 2017(Publication Date)
- Van Schaik Publishers(Publisher)
16310The capital investment decision
Learning outcomes
After studying this chapter, you should- understand the Net Present Value Method
- know how to calculate the net present value, for both a single sum and an annuity
- know how to apply the Net Present Value Method when purchasing shares
- know how to calculate the internal rate of return
- be able to apply the internal rate of return
- be able to apply the payback period method
- be able to make prudent decisions in the investment of capital.
Capital budgeting techniques
There is an extension or modification of the time value of money concept called the net present value, abbreviated to NPV. This is a sophisticated technique, providing a method whereby investment projects that yield cash inflows into the future may be valued in the present, which deals in net monetary amounts. This technique, together with two others, namely the internal rate of return and the payback period method, will be the focus of this chapter.Examples on the Statement of Financial Position that would involve application of the NPV method would be the organisation’s purchase of fixed assets and an investor’s purchase of shares in an organisation. We shall discuss these examples when we come to the detailed discussion on capital budgeting techniques later in this chapter.In the context of this book, an investment project will refer principally to the investment of funds in the purchase of fixed assets and shares. Since nobody can afford to invest money at a loss, the Net Present Value Method is a means of determining whether or not an investment will be a profitable proposition.A second technique, the internal rate of return (IRR), is also considered a sophisticated one and is indirectly related to the NPV. As the name implies, it is 164 intended to provide a rate of return
eBook - PDF- Robert Parrino, David S. Kidwell, Thomas Bates, Stuart L. Gillan(Authors)
- 2021(Publication Date)
- Wiley(Publisher)
10.2 Net Present Value 10-13 Concluding Comments on NPV Some concluding comments about the NPV method are in order. First, as you may have noticed, the NPV computations are rather mechanical once we have estimated the cash flows and the cost of capital. The real difficulty is estimating or forecasting the future cash flows. Although this may seem to be a daunting task, managers with experience in producing and selling a particular type of product can usually generate fairly accurate estimates of sales vol- umes, prices, and production costs. Most business managers are routinely required to make decisions that involve expectations about future events. In fact, that is what business is really all about—dealing with uncertainty and making decisions that involve risk. Second, estimating project cash flows over a long forecast period requires skill and judgment. There is nothing wrong with using estimates to make business decisions as long as they are based on informed judgments and not guesses. Problems can arise with the cash flow estimates when a project team becomes overly enamored with a project. In wanting a particular project to succeed, a project team can be too optimistic about the cash flow projections. It is therefore very important that capital budgeting decisions be subject to ongoing and postaudit review. In conclusion, the NPV approach is the method we recommend for making capital investment decisions. It provides a direct (dollar) measure of how much a project will increase the value of the firm. NPV also makes it possible to correctly choose between mutually exclu- sive projects. The accompanying table summarizes NPV decision rules and the method’s key advantages and disadvantages. DECISION MAKING EXAMPLE 10.1 The IS Department’s Capital Projects Situation Suppose you are the manager of the information systems (IS) department of the frozen pizza manufacturer we have been discussing.
eBook - ePubMaking the Compelling Business Case
Decision-Making Techniques for Successful Business Growth
- W. Messner(Author)
- 2013(Publication Date)
- Palgrave Macmillan(Publisher)
It is now time to revisit the result of the calculation: the NPV is negative and thus the calculation uncovers a non-profitable investment proposition. But what would happen if the rate of return drops from 5 per cent to 3.5 per cent? Changing the value in cell E18 to 3.5 per cent throws out a positive NPV in cell E16 and the investment proposition begins to make sense again. Alternatively, if the owner of the real estate manages to rent it out at higher rates, this could for example increase the cash inflow in the first two years to $20,000 and to $25,000 in the third and fourth year. Now the calculation shows a positive NPV of $1,115.Spreadsheets like the one in Figure 2.6 help to experiment with the input data and thus facilitate a deeper understanding of an investment’s otherwise hidden dynamics. This kind of experimenting is commonly referred to as sensitivity analysis and Section 6.6 examines its possibilities in greater detail.Summary
The firm’s wealth maximization goal (see Section 1.1 ) states that financial management should endeavor to maximize the NPV of the expected future cash flows by taking two basic parameters into account2 :The longer it takes to receive a cash flow, the lower the value decision makers place on the cash flow today.The greater the risk associated with receiving a future cash flow, the lower the value decision makers place on that cash flow today.The wealth maximization goal thus reflects the magnitude, timing, and risk associated with cash flows expected to be received in the future as a result of investment decisions. It tells financial management what investments are to be preferred and how to make decisions.However, people often fail to understand the simple mathematical rationale of the time value of money, which is really the only principle behind calculating NPV. Instead, they perceive some other methods as methodically easier to understand, apply them instead, and in this process often mess up the correctness of the calculation. NPV is always (!) the most appropriate approach to calculating business cases; Sections 2.3 –2.6 describe the most common alternative methods, highlight their weaknesses (and strengths, if at all), and explain why they are always (!) inferior to the NPV method when making decisions on investment propositions. Sometimes they are indeed appropriate to use, but the same decision can always (!) be reached with the much more straightforward NPV method. Chapter 5
eBook - PDFManagerial Accounting
Tools for Business Decision Making
- Jerry J. Weygandt, Paul D. Kimmel, Donald E. Kieso(Authors)
- 2015(Publication Date)
- Wiley(Publisher)
Discount rate The interest rate used in discounting the future net cash flows to determine present value. Internal rate of return (IRR) The interest rate that will cause the present value of the proposed capital expen-diture to equal the present value of the expected net annual cash flows. Internal rate of return (IRR) method A method used in capital budgeting that results in finding the interest yield of the potential investment. Net present value (NPV) The difference that results when the original capital outlay is subtracted from the discounted net cash flows. Net present value (NPV) method A method used in capital budgeting in which net cash flows are dis-counted to their present value and then compared to the capital outlay required by the investment. Post-audit A thorough evaluation of how well a project’s actual performance matches the original projections. Profitability index A method of comparing alternative projects that takes into account both the size of the investment and its discounted net cash flows. It is com-puted by dividing the present value of net cash flows by the initial investment. Required rate of return The rate of return manage-ment expects on investments, sometimes called the dis-count rate or cost of capital. GLOSSARY REVIEW 414 12 Planning for Capital Investments 1. BTMS Inc. wants to purchase a new machine for $30,000, excluding $1,500 of installa-tion costs. The old machine was bought five years ago and had an expected economic life of 10 years without salvage value. This old machine now has a book value of $2,000, and BTMS Inc. expects to sell it for that amount. The new machine would decrease operating costs by $8,000 each year of its economic life. The straight-line depreciation method would be used for the new machine, for a five-year period with no salvage value. Instructions (a) Determine the cash payback period. (b) Determine the approximate internal rate of return.
eBook - PDFManagerial Accounting
The Cornerstone of Business Decision Making
- Maryanne Mowen, Don Hansen, Dan Heitger, , Maryanne Mowen, Don Hansen, Dan Heitger(Authors)
- 2017(Publication Date)
- Cengage Learning EMEA(Publisher)
Now compute the present value of the profit earned on the investment. 2. CONCEPTUAL CONNECTION Compute the NPV of the investment. Compare this with the present value of the profit computed in Requirement 1. What does this tell you about the meaning of NPV? Exercise 12-39 Solving for Unknowns Each of the following scenarios is independent. Assume that all cash flows are after-tax cash flows. a. Thomas Company is investing $120,000 in a project that will yield a uniform series of cash inflows over the next 4 years. b. Video Repair has decided to invest in some new electronic equipment. The equipment will have a 3-year life and will produce a uniform series of cash savings. The NPV of the equipment is $1,750, using a discount rate of 8%. The IRR is 12%. OBJECTIVE 3 ▶ OBJECTIVE 1 ▶ 3 ▶ 4 ▶ Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-300 687 Chapter 12 Capital Investment Decisions c. A new lathe costing $60,096 will produce savings of $12,000 per year. d. The NPV of a project is $3,927. The project has a life of 4 years and produces the following cash flows: Year 1 $10,000 Year 3 $15,000 Year 2 $12,000 Year 4 ? The cost of the project is two times the cash flow produced in Year 4. The discount rate is 10%. Required: 1. If the internal rate of return is 14% for Thomas Company, how much cash inflow per year can be expected? 2. Determine the investment and the amount of cash savings realized each year for Video Repair. 3. For Scenario c, how many years must the lathe last if an IRR of 18% is realized? 4. For Scenario d, find the cost of the project and the cash flow for Year 4. Exercise 12-40 Net Present Value versus Internal Rate of Return Skiba Company is thinking about two different modifications to its current manufacturing pro-cess.
eBook - PDF- James Jiambalvo(Author)
- 2016(Publication Date)
- Wiley(Publisher)
Capital expenditure decisions are investment decisions involv- ing the acquisition of long-lived assets. A capital budget is the final list of approved acquisitions. Two of the primary methods for evaluating investment opportunities, which take into account the time value of money, are the Net Present Value Method (NPV) and the internal rate of return method (IRR). The Net Present Value Method equates all cash flows to their present values. If the sum of the present values of cash inflows and outflows (i.e., the NPV) is zero or positive, the return on the investment equals or exceeds the required return and the investment should be made. The internal rate of return method calculates the rate of return that equates the present value of the future cash flows to the initial investment. If this rate of return is equal to or greater than the required rate of return, the investment is warranted. LEARNING OBJECTIVE 2 Calculate the depreciation tax shield and evaluate long-run decisions, other than investment decisions, using time value of money techniques. In analyzing cash flows for a net present value analysis or an internal rate of return analysis, remember that depreciation is not a cash flow but the tax savings generated by depreciation are relevant to the analysis. The tax savings owing to depreciation are referred to as the depreciation tax shield. NPV and IRR are also used to evaluate long-run decisions that are not capital budgeting decisions. Examples include outsourcing decisions and decisions related to multiyear adver- tising campaigns. LEARNING OBJECTIVE 3 Use the payback period and the accounting rate of return methods to evaluate investment opportunities, and explain why managers may concentrate erroneously on the short-run profitability of investments rather than their net present values. The payback method evaluates capital projects in terms of how quickly the initial investment is recovered by future cash inflows.
eBook - PDFWeygandt's Managerial Accounting
Tools for Business Decision Making
- Jerry J. Weygandt, Paul D. Kimmel, Donald E. Kieso(Authors)
- 2017(Publication Date)
- Wiley(Publisher)
(p. 12-19). Capital budgeting The process of making capital expenditure decisions in business. (p. 12-1). Cash payback technique A capital budgeting technique that identifies the time period required to recover the cost of a capital investment from the net annual cash flow produced by the investment. (p. 12-5). Cost of capital The weighted-average rate of return that the firm must pay to obtain funds from creditors and shareholders. (p. 12-9). Discounted cash flow technique A capital budgeting technique that considers both the estimated net cash flows from the investment and the time value of money. (p. 12-6). Discount rate The interest rate used in discounting the future net cash flows to determine present value. (p. 12-6). Internal rate of return (IRR) The interest rate that will cause the pres- ent value of the proposed capital expenditure to equal the present value of the expected net annual cash flows. (p. 12-16). Internal rate of return (IRR) method A method used in capital bud- geting that results in finding the interest yield of the potential investment. (p. 12-16). Net present value (NPV) The difference that results when the orig- inal capital outlay is subtracted from the discounted net cash flows. (p. 12-6). Net present value (NPV) method A method used in capital budgeting in which net cash flows are discounted to their present value and then com- pared to the capital outlay required by the investment. (p. 12-6). Post-audit A thorough evaluation of how well a project’s actual perfor- mance matches the original projections. (p. 12-15). Profitability index A method of comparing alternative projects that takes into account both the size of the investment and its discounted net cash flows. It is computed by dividing the present value of net cash flows by the initial investment. (p. 12-14). Required rate of return The rate of return management expects on investments, sometimes called the discount rate or cost of capital.
eBook - PDF- Keith Cuthbertson, Dirk Nitzsche(Authors)
- 2014(Publication Date)
- Wiley(Publisher)
We can now think of ranking these projects according to their NPVs, from highest to lowest. Hence: NPV = CF 1 - KC 1 (1 + r) + CF 2 - KC 2 (1 + r) 2 - KC 0 KC i VALUATION TECHNIQUES 90 When funds are available, invest in all projects for which the NPV is positive. However, note that if there is a capital constraint on finance, then the NPV criterion is mis- leading (see ‘performance index’ below). Valuation of the whole firm The PV approach can be used to value the whole firm. Here we merely aggregate the free cash flows and capital costs from all the firm’s current and planned projects and find their total NPV. It can be shown that: If managers invest in all positive NPV projects, then this maximises the value of the firm and maximises the returns to shareholders. But if today we offered to give another Bank B $2,420 in two years time, how much would Bank B give us today (as a loan)? It would give us today: So once again we find that our profits are worth $2000 today – but this is less than the capital cost of project of KC $2100, so we would not go ahead with the deli. As long as you adjust any cash flows to the same point in time and only then compare them, you will always came to the same decision about the viability of an investment. DPV = $2420> (1.1) 2 = $2000 The PV approach is one way in which stock analysts try to calculate the ‘fair value’ of the firm to see if it is currently over- or undervalued. Suppose that by summing the NPVs of all the divisions of the firm the analyst finds that the NPV of the firm is V firm $100m. If this is an all-equity firm and there are N 10m shares outstanding, then the ‘fair value’ of these shares is V s $10 per share ( 100/10). If the shares are currently trading at P $9, then the analyst might recommend purchasing this undervalued share.
- Josh Lerner, Ann Leamon(Authors)
- 2023(Publication Date)
- Wiley(Publisher)
With APV, the valuation task is divided into three steps. First, the cash flows are valued, ignor- ing the capital structure. The cash flows of the firm are discounted in the same manner as under the NPV method, except that a different discount rate is used. We essentially assume that the company is financed totally by equity. This implies that the discount rate should be calculated using an unlev- ered beta, rather than the levered beta used to compute the WACC used in the NPV analysis. The discount rate is calculated using the capital asset pricing model shown in Equations 4.5 and 4.6. Second, the tax benefits associated with the capital structure are estimated. The NPV of the tax savings from tax-deductible interest payments is valuable to a company and must be quantified. The interest payments will change over time as debt levels rise or fall. By convention, the discount rate often used to calculate the NPV of the tax benefits is the pre-tax rate of return on debt. This will be lower than the cost of equity, because the claims of debt holders rank higher than those of ordinary shareholders and, therefore, are a safer stream of cash flows. Finally, NOLs available to the company must be quantified. NOLs can be offset against pre- tax income and often provide a useful source of cash to a company in its initial years of profit- able operation. For instance, if a company has $10 million of NOLs and the prevailing tax rate is 18 An introduction to R and a number of helpful articles for the R beginner can be found at http://r-project.org/about.html. Similarly, information for Python beginners can be found at http://python.org/about/gettingstarted. 116 Chapter 4 Assigning Value 40 percent, the company will have tax savings of $4 million. Note, however, that this ignores the time value of money. The NPV of the NOLs will only be $4 million if the firm has taxable income of $10 million in its first year.
- Peter Harris(Author)
- 2010(Publication Date)
- Routledge(Publisher)
The required information is a series of projected annual earnings in the form of cash available for distribution to the risk-holding investor (the equity holder). These projections of earnings are then aggregated over the number of years required for the aggregated sum to equal the level of the initial investment – the number of years the distributable cash earnings take to repay the initial investment with any future distributed earnings representing reward for the risk undertaken. This assessment of risk is founded on the assumption that once the initial investment has been repaid then risk is removed and logically the quicker risk is removed the more desirable is the investment. In short, the rationale is that a pay-back period of five years is less risky than a payback period of 10 years, but hotels are known to be long-lived investments. Many of the most desired hotels have traded as such for decades. This methodology fails to take into account not only any value attributed to the continuing ownership of the business but also any risk inherent in the projection of earning over a period of time. The pay-back methodology seems at best a very modest approach to the assessment of the risk being undertaken and indeed is somewhat contradictory. In this method, if a short pay-back is perceived as lower risk than a long payback, then the assumption must be that a higher return offers less risk than a lower return – a 5 year pay-back offers a 20 per cent return, a 10-year payback, a 10 per cent return. This flies in the face of all other commercial logic which suggests that the relationship between risk and reward is contrary.Net Present ValueThis approach builds on the pay-back method by applying the return required by the investor to the cash earnings. It improves on the pay-back method by recognizing the time over which the investment is made. The investor decides that an average of X per cent return per annum is required. The decision on the level of the return required is based upon the return available from alternative uses of the cash to be invested.
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