Business
Positive NPV
Positive NPV, or Net Present Value, indicates that an investment or project is expected to generate more cash inflows than outflows over time. It is a key financial metric used to evaluate the profitability of an investment by discounting future cash flows to their present value. A positive NPV suggests that the investment is expected to add value to the business.
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10 Key excerpts on "Positive NPV"
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 - PDFManagerial Accounting
Tools for Business Decision-Making
- Jerry J. Weygandt, Paul D. Kimmel, Donald E. Kieso, Ibrahim M. Aly(Authors)
- 2018(Publication Date)
- Wiley(Publisher)
However, companies rarely are able to adopt all positive-NPV proposals. First, proposals are often mutually exclusive. This means that if the company adopts one proposal, it would be impossible also to adopt the other proposal. For example, a company may be considering the purchase of a new packaging machine and is looking at various brands and models. It needs only one packaging machine. Once the company has determined which brand and model to purchase, it will not purchase the others—even though they may also have positive net present values. Even in instances where projects are not mutually exclusive, managers must often choose between various positive-NPV projects because the company’s resources are limited. For ex- ample, the company might have ideas for two new lines of business, each of which has a projected Positive NPV. However, both of these proposals require skilled personnel, and the company determines that it will not be able to find enough skilled personnel to staff both proj- ects. Management will have to choose the project that it thinks is a better option. When choosing between alternative proposals, it is tempting simply to choose the project with the higher NPV. Consider the example of two mutually exclusive projects in Illustration 13.17 . Each is assumed to have a 10-year life and a 12% discount rate. Project A Project B Initial investment $40,000 $ 90,000 Net annual cash inflow 10,000 19,000 Salvage value 5,000 10,000 Present value of net cash flows ($10,000 × 5.65022) + ($5,000 × 0.32197) 58,112 ($19,000 × 5.65022) + ($10,000 × 0.32197) 110,574 ILLUSTRATION 13.17 Investment information for mutually exclusive projects From the information in Illustration 13.17, we can calculate the net present values of Project A and Project B as shown in Illustration 13.18. ILLUSTRATION 13.18 Net present value calculation Project A Project B Present value of net cash flows $58,112 $110,574 Initial investment 40,000 90,000 Net present value $18,112 $ 20,574
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.
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- Don Hansen, Maryanne Mowen, Dan Heitger, , Don Hansen, Maryanne Mowen, Dan Heitger(Authors)
- 2021(Publication Date)
- Cengage Learning EMEA(Publisher)
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Chapter 19 Capital Investment 983 decisions in the presence of competing alternatives. In reality, it can be shown that the NPV model is generally preferred to the IRR model when choosing among mutually exclusive alternatives. NPV Compared with IRR NPV and IRR both yield the same decision for independent projects. For example, if the NPV is greater than zero, then the IRR is also greater than the required rate of return; both models signal the correct decision. For competing projects, however, the two methods can produce different results. Intuitively, we believe that, for mutually exclusive projects, the project with the highest NPV or the highest IRR should be chosen. Since it is possible for the two methods to produce different rankings of mutually exclusive projects, the method that consistently reveals the wealth-maximizing project should be preferred. As will be shown, the NPV method is that model. NPV differs from IRR in two major ways. First, NPV assumes that each cash inf low received is reinvested at the required rate of return, whereas the IRR method assumes that each cash inf low is reinvested at the computed IRR. Second, the NPV method measures profitabil-ity in absolute terms, whereas the IRR method measures it in relative terms. Because NPV is measured in absolute terms, it is affected by the size of the investment, whereas IRR is size inde-pendent. For example, an investment of $100,000 that produces a cash f low one year from now of $121,000 has the same IRR (21 percent) as an investment of $10,000 that produces a cash f low one year from now of $12,100. Note, however, that the NPV is $10,000 for the first invest-ment and $1,000 for the second.
eBook - PDFCorporate Finance
Theory and Practice in Emerging Economies
- Sunil Mahajan(Author)
- 2020(Publication Date)
- Cambridge University Press(Publisher)
The NPV of course can be easily determined. C 0 C 1 C 1,000 −3,000 2,500 These cash flows have no feasible IRR. However, at 10 per cent COC, the NPV can be quite easily determined to be 339. Mutually Exclusive Projects Until now, we have focused on a single project to decide whether the company should invest or not. We have relied on two methods, namely the NPV and the IRR for our decision. The outcome of this evaluation process is quite straight forward—a decision either to invest in or reject the project. Both the methods, as we have seen, give similar results and there is no conflict in the two methods. A Positive NPV is possible only if the IRR is greater than the COC in which case an investment in the project is recommended. If, on the other hand, NPV is negative, IRR is less than the COC. Both methods, therefore, suggest a rejection of the project. Life is never so simple and usually presents more complicated challenges. 1. We may have projects with more complicated cash flows, and as we discussed earlier, there could be more than one change in the cash flow sign—from negative to positive or vice versa. Capital Budgeting | 121 2. Though theory assumes that funds in a free financial market would be available for all Positive NPV projects, budgetary constraints are a harsh reality for many companies. Budgetary limitations often compel a choice amongst various projects, all of which may be value accretive. How to choose among these projects, to add maximum value to the company, becomes another challenging facet for management practitioners. We have discussed PI as a tool to resolve budgetary constraints earlier in the chapter. 3. At times, two or more projects may be mutually exclusive. The choice of one project implies the exclusion of the other. Thus, only one of the projects can be taken up for investment, but not both. A piece of land that the company owns can be used to either construct a retail mall or a housing complex.
eBook - PDF- Jerry J. Weygandt, Paul D. Kimmel, Donald E. Kieso(Authors)
- 2018(Publication Date)
- Wiley(Publisher)
25-14 CHAPTER 25 Planning for Capital Investments As Project B has the higher NPV, it would seem that the company should adopt it. How- ever, Project B also requires more than twice the original investment of Project A. In choosing between the two projects, the company should also include in its calculations the amount of the original investment. One relatively simple method of comparing alternative projects is the profitability index. This method takes into account both the size of the original investment and the discounted cash flows. The profitability index is calculated by dividing the present value of net cash flows that occur after the initial investment by the amount of the initial investment, as Illustration 25.19 shows. The profitability index allows comparison of the relative desirability of projects that require differing initial investments. Note that any project with a Positive NPV will have a profitability index above 1. The profitability index for each of the mutually exclusive projects is calculated in Illustration 25.20. In this case, the profitability index of Project A exceeds that of Project B. Thus, Project A is more desirable. Again, if these were not mutually exclusive projects and if resources were not limited, then the company should invest in both projects since both have Positive NPVs. Additional considerations related to preference decisions are discussed in more advanced courses. Risk Analysis A simplifying assumption made by many financial analysts is that projected results are known with certainty. In reality, projected results are only estimates based upon the fore- caster’s belief as to the most probable outcome. One approach for dealing with such uncer- tainty is sensitivity analysis. Sensitivity analysis uses a number of outcome estimates to get a sense of the variability among potential returns.
eBook - PDF- James Jiambalvo(Author)
- 2016(Publication Date)
- Wiley(Publisher)
However, managers may not make investments in projects with substantial NPVs (or projects with IRRs greater than the required rate of return) because they are evaluated in terms of short-run accounting profit, which may decrease when the projects are undertaken. Decision Making IN SIGHT APPENDIX A USING EXCEL ® TO CALCULATE NPV AND IRR In this appendix, you will see how to use functions in Excel® to calculate the net present value (NPV) and internal rate of return (IRR) of investment opportunities. Let’s focus on the data related to the paint-spraying equipment example presented in Illustration 9-3. The first step in performing present value calculations in Excel® is to input the relevant cash flows into a spreadsheet: cells B2–G2 in Illustration A9-1. As indicated, purchase of the paint-spraying equipment requires a $70,000 payment at time 0. The company buying the equip- ment will save $21,000 each year for 5 years and sell the equipment for $5,000 at the end of the fifth year. Thus, the cash inflow at the end of year 5 is $26,000 ($21,000 + $5,000). The required rate of return on the investment is 0.12, which we input in cell B5. To calculate net present value, we need to input the NPV function into a cell; click on cell B8. Now click on Formulas, then click on Financial, and then click on NPV, which is one of the programs in the Financial section. The first item we input into the NPV function is the required rate of return, which is in cell B5. The NPV function calculates the present value of cash flows assuming the first cash flow occurs at the end of year 1. So, be careful: Don’t include the cash flow at time 0 at this point. Simply input the cash flows from C2 through G2. At this point, your screen should be similar to the one in Illustration A9-2. ILLUSTRATION A9-1 Input data into Excel ® ILLUSTRATION A9-2 Using the NPV function Appendix A 351 Now click OK, go back to cell B8, and add the cash flow occurring at time 0, which is in cell B2.
eBook - PDF- Robert Parrino, David S. Kidwell, Thomas Bates(Authors)
- 2016(Publication Date)
- Wiley(Publisher)
The following table shows the NPVs for the two projects at several discount rates: Discount Rate NPV of Project A NPV of Project B 0% €50.0 €65.0 5% 34.5 42.9 10% 21.5 24.9 13% 14.8 15.7 15% 10.6 10.1 20% 1.3 − 2.2 25% − 6.8 − 12.6 30% − 13.7 − 21.3 IRR 20.7% 19.0% Notice that the project with the higher NPV depends on what rate of return is used to discount the cash flows. Our example shows a conflict in ranking order between the IRR and NPV methods at discount rates between 0 and 13 per cent. In this range, project B has the lower IRR but it has the higher NPV and should be the project selected. If the discount rate is above 15 per cent, however, project A has the higher NPV as well as the higher IRR. In this range, there is no conflict between the two evaluation methods. Now take a look at Exhibit 10.11, which shows the NPV profiles for projects A and B. As you can see, there is a point, called the crossover point , at which the NPV profiles for projects A and B intersect. The crossover point here is at a discount rate of 14.3 per cent. For any cost of capital above 14.3 per cent, the NPV for project A is higher than that for project B; thus, project A should be selected if its NPV is positive. For any cost of capital below the crossover point, project B should be selected. Another conflict involving mutually exclusive projects concerns comparisons of projects that have significantly different costs. The IRR does not adjust for these differences in size. What the IRR gives us is a rate of return on each unit of currency invested. In contrast, the NPV method computes the total monetary value created by the project. The difference in results can be sig-nificant, as can be seen in Decision-Making Example 10.2. crossover point The discount rate at which the NPV profiles of two projects cross and, thus, at which the NPVs of the projects are equal.
eBook - PDFGuidebook For Supporting Decision Making Under Uncertainties: Today's Managers, Tomorrow's Business
Today's Managers, Tomorrow's Business
- Ettore Piccirillo, Massimo Noro(Authors)
- 2008(Publication Date)
- World Scientific(Publisher)
YIELD 11.3% Payback (n. years) 4.3 NET PRESENT VALUE 219 ENHANCED NPV 95 61 Guidebook for Supporting Decision-Making Under Uncertainties Table 4.2. Summary of the Cash Flow and financial measures for projects (2a) and (2b), which are representative of a fast return example. Figures in '000 0 1 2 3 4 5 Years year 1 year 2 year 3 year 4 year 5 year 6 (2a) Net Cash Flow in constant terms (100) 80 40 20 10 5 6.00% NPV factors 1.000000 0.943396 0.889996 0.839619 0.792094 0.747258 1.96% Enh NPV factors 1.000000 0.980764 0.925249 0.839619 0.732883 0.615343 Indicators Sum Acid Test Capital Scale Index TOTAL REVENUES 155 0.65 1.29 NPV REVENUES 140 0.72 1.43 Enhanced NPV REVENUES 143 0.70 1.40 D.C.F. YIELD 29.3% Payback (n. years) 1.5 NET PRESENT VALUE 40 ENHANCED NPV 43 (2b) Net Cash Flow in constant terms (1,000) 800 400 200 100 50 6.00% NPV factors 1.000000 0.943396 0.889996 0.839619 0.792094 0.747258 1.96% Enh NPV factors 1.000000 0.980764 0.925249 0.839619 0.732883 0.615343 Indicators Sum Acid Test Capital Risk Index TOTAL REVENUES 1,550 0.65 1.94 NPV REVENUES 1,395 0.72 2.15 Enhanced NPV REVENUES 1,427 0.70 2.10 D.C.F. YIELD 29.3% Payback (n. years) 1.5 NET PRESENT VALUE 395 ENHANCED NPV 427 still captures the difference in the scale of the capital involved, and jumps from 1.83 to 2.74, revealing that the ‘capital risk’ involved with the project described in Case 1a is smaller than that in Case 1b. In the second example (see Table 4.2), we considered two projects (2a and 2b) in the same time-span of predicted cash flows, which represent fast-time return. Here, again, the Capital Scale index increases going from 1.40 to 2.10 when the initial capital involved increases from 100 to 1000. It is even more interesting to perform a cross comparison within Table 4.3. The total returns of Project 1a and 2a are the same (if we for-get for the moment the time-value of money) yielding a total revenue of 155.
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