Problems with NPV

12 Key excerpts on "Problems with NPV"

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  eBook - ePub

  Strategic Finance for Criminal Justice Organizations

  • 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.

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  Fundamentals of Corporate Finance

  • 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.

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  Evaluating Capital Projects

  • Ahmed Riahi-Belkaoui(Author)
  • 2000(Publication Date)
  • Praeger

    (Publisher)

  In Section IV the assumptions underlying NPV are examined, and then risk/return and the decision-making process are considered. Section V contains the discussion and conclusions. I. Introduction: Capital Budgeting Decision-Making A fundamental paradigm in financial economics specifies how firms should make capital investment decisions. Specifically, the focus of the decision process • is on net present value (NPV), • is on cash flows, and • takes projectriskinto account By accepting positive net present value projects the value of thefirmis maximized. This is reasonable, intuitive, and, in theory, workable and is employed by many larger firms in developed countries, The question addressed in this paper is: "Does the same approach to capital investment decision-making—stressing cash flows, risk, and net present value—exist in other countries, especially newly industrialized or developing countries in the Asia Pacific region?" This question arose when one of the authors spoke with the chief financial officer (CFO) of the chemical division of a major Asia Pacific firm. During the discussion the CFO commented that he and his firm know all about net present value, but they did not use it when making capital investment decisions. Subsequent investigation indicated that information on the use of NPV in the Asia Pacific region is available only for Japan. Hodder (1986) examined how Japanesefirms made capital investment decisions. He found that while somefirmsused discounted cash flow and net present value, they were in the minority. Rather "...the vast majority of Japanese firms appear to assess a project's 'profitability' based on cashflowprojections that include imputed interest charges on their investment in that project" (p. 18).

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  Basic principles of financial management

  • Brümmer LM, Hall JH, Du Toit E(Authors)
  • 2017(Publication Date)
  • Van Schaik Publishers

    (Publisher)

  163

  10

  The 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

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  Budgeting Basics and Beyond

  • Jae K. Shim, Joel G. Siegel, Allison I. Shim(Authors)
  • 2011(Publication Date)
  • Wiley

    (Publisher)

  An advantage of NPV is that it considers the time value of money. A disadvantage is the subjectivity in determining expected annual cash inflows and expected period of benefit.

  Recommendation: If a proposal is supposed to provide a return, invest in it only if it provides a positive NPV. If two proposals are mutually exclusive (acceptance of one precludes acceptance of another), accept the proposal with the highest present value.

  Note: In an advanced automated environment, the terminal value requires managers to forecast technological, economic, operational, strategic, and market developments over the investment's life so that a reasonable estimate of potential value may be made.

  Caution: Using the return rate earned by the company as the discount rate may be misleading in certain cases. It may be a good idea to look at the return rate investors earn on similar projects. If the minimum rates selected are based on the company's return on average projects, an internal company decision will occur that helps to increase the corporate return. Yet if the company is earning a very high rate of return, one will take a lot of good projects and also leave some good ones. What if the project left would really enhance value?

  If the corporate return rate is below what investors can earn elsewhere, managers delude themselves in believing it is an attractive investment. The project may involve below-normal profitability and lower per-share value and result in lower creditor and investor ratings of the firm.

  The net present value method typically provides more reliable signals than other methods. By employing NPV and using best estimates of reinvestment rates, the most advantageous project can be selected.

  Example 6

  You are considering replacing Executive 1 with Executive 2. Executive 2 requires a payment on contract signing of $200,000. He will receive an annual salary of $330,000. Executive 1's current annual salary is $140,000. Executive 2 is superior in talent. You expect there will be an increase in annual cash flows from operations (ignoring salary) of $350,000 for each of the next 10 years. The cost of capital is 12 percent.

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  Cornerstones of Cost Management

  • Don Hansen, Maryanne Mowen(Authors)
  • 2017(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  Chapter 19 Capital Investment 1021 3. Calculate the net present value (NPV) for independent projects. • NPV is the difference between the present value of future cash fl ows and the initial invest-ment outlay. • To use the model, a required rate of return must be identi fi ed (usually, the cost of capital). The required rate of return is used to calculate the present value of future cash fl ows. • If the NPV > 0, then the investment is acceptable. 4. Compute the internal rate of return (IRR) for independent projects. • The IRR is computed by fi nding the interest rate that equates the present value of a proj-ect ’ s cash in fl ows with the present value of its cash out fl ows. • If IRR is greater than the cost of capital, then the investment is acceptable. 5. Tell why NPV is better than IRR for choosing among mutually exclusive projects. • NPV measures the increase in a fi rm ’ s wealth caused by a project. Thus, choosing the pro-ject that increases wealth the most makes sense. • IRR sometimes will signal that one project is better than a second, even though the second increases wealth more. • NPV consistently provides the correct signal when choosing among competing projects and is preferred to IRR. 6. Convert gross cash fl ows to after-tax cash fl ows. • Accurate and reliable cash fl ow forecasts are absolutely critical for capital budgeting analyses. • All cash fl ows in a capital investment analysis should be after-tax cash fl ows. • There are two different, but equivalent, ways to compute after-tax cash fl ows: the income method and the decomposition method. • Although depreciation is not a cash fl ow, it does have cash fl ow implications because tax laws allow depreciation to be deducted in computing taxable income. • Accelerated methods of depreciation are preferred because of the tax bene fi ts created. 7. Describe capital investment for advanced technology and environmental impact settings.

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  CFIN

  • Scott Besley, Eugene Brigham, Scott Besley(Authors)
  • 2021(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  In making the ac- cept/reject decision, most large, sophisticated firms, such as IBM, General Electric, and General Motors, calculate and consider multiple measures because each provides decision makers with a somewhat different piece of relevant information. Traditional payback and discounted payback provide information about both the risk and the liquidity of a project. A long payback means (1) the investment dollars will be locked up for many years, hence the project is relatively illiquid; and (2) the project’s cash flows must be forecast far out into the future, hence the project is probably quite risky. 10 A good analogy for this is the bond valuation process. An investor should never compare the yields to maturity on two bonds without considering their terms to ma- turity, because a bond’s riskiness is influenced by its maturity. NPV is important because it gives a direct mea- sure of the dollar benefit (on a present value basis) to the firm’s shareholders, so we regard NPV as the best single measure of profitability. IRR also measures profitability, but here it is expressed as a percentage rate of return, which many decision makers, especially nonfinancial managers, seem to prefer. Further, IRR contains information concerning a project’s “safety margin,” which is not inherent in NPV. To illustrate, consider the following two projects: Project T costs $10,000 at t 5 0 and is expected to return $16,500 at the end of one year, while Project B costs $100,000 and has an expected payoff of $115,500 after one year. At a 10 percent required rate of return, both projects have an NPV of $5,000, so by the NPV rule we should be indifferent between the two. However, Project T actually provides a much larger margin for er- ror. Even if its realized cash inflow turns out to be almost 40 percent below the $16,500 fore- cast, the firm will still recover its $10,000 investment.

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  Net Present Value and Risk Modelling for Projects

  • Martin Hopkinson(Author)
  • 2017(Publication Date)
  • Routledge

    (Publisher)

  These examples illustrate how the use of NPV modelling can be extended to include non-financial benefits. Where this is acceptable, consideration of a project’s business case is made much easier by the conflation of all costs and benefits into the single dimension of cash. However, there are limits to the utility of this approach, since there are no accepted methods for valuing some impacts. Even where there is guidance on the issue, the valuation of some impacts may be controversial or the guidance interpreted inappropriately. For these reasons, it is recommended that all assumptions used to translate project benefits and disbenefits into cash values are clarified in reports that include NPV modelling results.

  A General Plan for Development of Net Present Value Models

  As described in the earlier sections of this chapter, the first steps in the development of an NPV model are to determine its purpose and identify the relevant costs and benefits. The subsequent steps involve planning, building and using the model. The following general plan has been adapted from Danielle Stein Fairhurst’s book Using Excel for Business Analysis (2012), which I would recommend as being a useful and accessible account of the subject:

    1. identify the decision(s) to be supported by the model;

    2. identify and structure the relevant costs and benefits;

    3. identify the users of the model;

    4. assign modelling tasks;

    5. build inputs and record associated assumptions;

    6. build calculations and workings and record associated assumptions;

    7. build outputs: summaries, charts and reports;

    8. peer review of the draft model;

    9. update model in response to peer review;

  10. formal model quality assurance (QA) check;

  11. take relevant decision(s) and review other insights identified by modelling;

  12. identify decisions (if any) to be supported by the next iteration of modelling;

  13. repass the process from point 2 or archive the model as appropriate.

  Good Spreadsheet Design Practice

  As a model is being built, there are a number of practices that can help improve its transparency and avoid errors. Again, Using Excel for Business Analysis

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  Financial Aspects of Marketing

  • Keith Ward(Author)
  • 2013(Publication Date)
  • Routledge

    (Publisher)

  However, money has a time value and if we are to make sensible decisions we need to incorporate the real value of future cash flows into our evaluation criteria. We can achieve this by applying discount rates to all future cash flows so that we bring them back to their equivalent present value, which makes all the project cash flows directly comparable. The most common way of doing this is to select a discount rate for the company and to apply this to all the cash flows of the project. A positive net present value indicates that the financial return from the investment is acceptable, but the opportunity costs evaluation against other potential investments must still be done. This requires comparison of what benefits could be achieved by investing in a different mix of projects and where there are constraints on the total amount of capital which can be invested, this comparison is very important. In such a situation of capital rationing, the profitability index can be used to compare relative investment returns between projects; this is done by dividing the present value of the net inflows by the value of the initial investment.

  Table 7.25 Comparison of internal rate of return (IRR) and accounting return on investment

  Several major investment evaluation techniques are used by companies: 1  payback period; 2  discounted payback period; 3  Discounted cash flow (a)  net present value (NPV) (b)  internal rate of return (IRR); 4  Accounting return on investment (ARR).

  These provide different views of any project and no single criterion can be regarded as giving the answer, so many companies use a combination of techniques and adjust the results to allow for the relative risk of the investment being examined.

           

  Appendix

  New car example using financial statements comparison Resumé

  Our sales and marketing director’s car cost £21 000 and is assumed to have a £6000 residual value at the end of three years. A fuel efficiency device becomes available for £4500 with projected savings of £2000 per year.

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  Managerial Accounting

  • James Jiambalvo(Author)
  • 2016(Publication Date)
  • Wiley

    (Publisher)

  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. The accounting rate of return method evaluates capital projects in terms of the ratio of average after-tax accounting income to the average investment. Both of these methods have the major limitation that they ignore the time value of money. Managers who want to maximize shareholder wealth should evaluate investment opportunities using the net present value method or the internal rate of return method. In some cases, however, projects with a positive net present value or with an internal rate of return greater than required may have a nega- tive effect on short-run income. Although these projects may be quite valuable to the long-run success of the firm, managers may not approve them because they fear that their own job performance will receive negative evaluations if short-run income is reduced. SUMMARY OF LEARNING OBJECTIVES Capital budgeting decisions involve estimation of incremental cash inflows and out- flows. Since the cash flows don’t occur in the same periods and because a dollar today is worth more than a dollar tomorrow, we need to take into account the time value of money by using the net present value (NPV) approach or the internal rate of return (IRR) approach. 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.

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  Corporate Finance

  Theory and Practice in Emerging Economies

  • Sunil Mahajan(Author)
  • 2020(Publication Date)
  • Cambridge University Press

    (Publisher)

  Managers are paid to take decisions. They cannot sit back and relax or spend time playing golf in the afternoon after having once decided to invest in a project. A constantly changing environment leads to the re-evaluation of earlier decisions, as and when warranted. Changes in cash flows and the consequent risk of the project implies that managers need to estimate and manage such risks. There are various methods to do so. A discussion of these methods is beyond the scope of this book. KEY CONCEPTS 1. Capital-budgeting decisions have a significant impact on a company’s fortunes over long term. 2. A project’s worth is based on the cash-flow generation and not accounting figures. 3. A company must select projects that have the potential to generate positive NPV. Net Present Value is superior to alternative capital-budgeting methods. 4. If two projects are mutually exclusive, the one with the higher NPV is selected. 5. The increase in the value of the firm from its capital budget for the year is the sum of the NPVs of all accepted projects. 6. Internal rate of retrun, payback period and ARR are the other methods employed to evaluate projects. 7. Cash flows for a project are incremental in nature, include opportunity costs, exclude sunk costs, recognize cannibalization and take into account taxes and inflation. What needs to be estimated are ‘post-tax incremental cash flows’. 8. Cash flows must include depreciation and other non-cash expenses. 116 | Corporate Finance 9. Cash flows for a project comprise initial, operating and terminal cash flows. 10. The impact of inflation must be taken into account in determining future cash flows. 11. Future cash flows are mere estimates and could turn out to be very different. The risk embedded in cash flow estimation must be taken into consideration. CHAPTER QUESTIONS 1. Capital budgeting is not a daily activity. Why is it still so critical to a company’s long-term future? 2.

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  Managerial Accounting

  Tools for Business Decision-Making

  • Jerry J. Weygandt, Paul D. Kimmel, Donald E. Kieso, Ibrahim M. Aly(Authors)
  • 2018(Publication Date)
  • Wiley

    (Publisher)

  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 Capital Budgeting Challenges 603 Project B has the higher NPV, and so it would seem that the company should adopt B. Note, however, that 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 considers both the size of the original investment and the discounted cash flows. The profitability index is calculated by dividing the present value of cash flows that occur after the initial investment by the initial investment. Illustration 13.19 shows the formula. Present Value of Net Cash Flows  Initial Investment  Profitability Index ILLUSTRATION 13.19 Formula for profitability index The profitability index makes it possible to compare the relative desirability of projects that require different initial investments (see Decision Tools). Note that any project with a pos- itive NPV will have a profitability index above 1. The profitability index for the two projects is calculated in Illustration 13.20. Profitability Index = Present Value of Net Cash Flows Initial Investment Project A Project B $58,112 = 1.45 $110,574 = 1.23 $40,000 $90,000 ILLUSTRATION 13.20 Calculation of profitability index 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 matters to consider in preference decisions are discussed in more advanced courses.

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