Question 1: Explain the theoretical rationale for the NPV approach to investment appraisal and compare the strengths and weaknesses of the NPV approach to two other commonly used approaches. (30 marks)
This first section of this paper will provide a brief explanation on theoretical rationale for the net present value (NPV) method of investment appraisal and then compare its strengths and weaknesses to two alternative methods of investment appraisal, those of internal rate of return (IRR) and pay-back.
Theoretical rationale for the NPV approach
The net present value rule or NPV devised by Hirshleifer (1958), is the fundamental model of how firms decide whether to invest in a project, commonly known as the ‘investment decision’, or
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G is also happy to invest because they can borrow against the future payoff of the investment. By investing G gets £20,000 more to spend today (£200,000 less £180,000). It would pay for either investor to borrow to invest in the opportunity due to the returns on offer.
Despite the reality of known imperfections in capital markets (e.g. taxation, transaction costs, asymmetric information), overall the use of NPV makes sense as a corporate objective. Certain ‘imperfections’ can be modelled into financials, providing a more realistic picture. Brealey et al (2008) state that the use of NPV for uncertain cash flows makes sense too, providing there is free access to competitive capital markets. This is due to when affirm chooses only positive-NPV projects, they will be meeting the shareholders and firms objective of maximising wealth. Instead of solely seeking a maximisation of wealth that might negatively impact in other areas (e.g. future profits, return on investment etc), NPV accounts for the time value of money, opportunity cost of capital and differences in project rates of return.
Comparison of the strengths and weaknesses of the NPV approach to two other commonly used approaches
This report will now focus on comparing the strengths and weaknesses of the NPV approach to two other investment appraisal approaches, internal rate of return (IRR) and pay-back.
Net present value (NPV)
The NPV approach asks
10. What is the net present value (NPV) of a long-term investment project? Describe how managers use NPVs when evaluating capital budget proposals.
In the case of Worldwide Paper Company we performed calculations to decide whether they should accept a new project or not. We calculated their net income and their cash flows for this project (See Table 1.6 and 1.5). We computed WPC’s weighted average cost of capital as 9.87%. We then used the cash flows to calculate the company’s NPV. We first calculated the NPV by using the 15% discount rate; by using that number we calculated a negative NPV of $2,162,760. We determined that the discount rate of 15% was out dated and insufficient. To calculate a more accurate NPV for the project, we decided to use the rate of 9.87% that we computed. Using this number we got the NPV of $577,069. With the NPV of $577,069 our conclusion is to accept this
Net Present Value (NPV) calculates the sum of discounted future cash flows and subtracting that amount with the initial investment of the project. If the NPV of a project results in a positive number, the project should be undertaken. It is the most widely used method of capital budgeting. While discount rate used in NPV is typically the organization’s WACC, higher risk projects would not be factored in into the calculation. In this case, higher discount rate should be used. An example of this is when the project to be undertaken happens to be an international project where the country risk is high. Therefore, NPV is usually used to determine if a project will add value to the company. Another disadvantage of NPV method is that it is fairly complex compared to the other methods discussed earlier.
Account for time. Time is money. We prefer to receive cash sooner rather than later. Use net present value as a technique to summarize the quantitative attractiveness of the project. Quite simply, NPV can be interpreted as the amount by which the market
NPV and IRR: When examining the NPV and the IRR of the Merseyside project, the numbers were very attractive. It had a positive net present value and an IRR above 10 percent. By these numbers, along with others,
2. Net Present Value – Secondly, Peter needs to investigate the Net Present Value (NPV) of each project scenario, i.e. job type, gross margin, and # new diamonds drills purchased. The NPV will measure the variance of the present value of cash outflow (drilling equipment investment) versus the future value of cash inflows (future profits), at the benchmark hurdle rate of 20%. A positive NPV associated with the investment means that the investment should be undertaken as it exceeds the minimum rate of return. A higher NPV determines which project scenario will have the highest return on cash flow, hence determining the most profitable investment in terms of present money value.
We valued the company using four different methods; Net Present Value, Internal Rate of Return, Modified Internal Rate of Return and Profitability Index. We began with the Net Present Value, or NPV, calculation. NPV values an investment’s profitability based on the projected future cash inflows and outflows of the investment, discounted back to present value using the WACC. The calculations for NPV are presented in Appendix 2. We started by separating cash inflows and outflows by each year. We used Bob Prescott’s estimates for the revenue per year and related operating costs of cost of goods sold as
There are several traditional methods that can be used in appraising investment decisions. For instance, the net present value method (NPV) which entails estimating the costs and revenues of a project and discounting these figures to get their present values. Projects with the biggest positive net present value are the ones chosen as they represent the best stream of benefits of investing in the project over and above recovering the cost of initiating the projects. The discount rate is another method which is similar to the net present value method but reflects more on the time preference. This approach may focus on the opportunity cost of
1. The net present value is the projects present value of inflows minus its cost. It shows us how much the project contributes to the shareholders wealth. The NPV of each franchise are:
Evaluating the risks, calculating the probability of success, and factoring in the projected profit from sales will provide a clearer NPV to be compared with other projects in the
Finally, in order to complete a more accurate comparison between the two projects, we utilized the EANPV as the deciding factor. Under current accepted financial practice, NPV is generally considered the most accurate method of predicting the performance of a potential project. The duration of the projects is different, one lasts four years and one lasts six years. To account for the variation in time frames for the projects and to further refine our selection we calculated the EANPV to compare performance on a yearly basis.
NPV analysis uses future cash flows to estimate the value that a project could add to a firm’s shareholders. A company director or shareholders can be clearly provided the present value of a long-term project by this approach. By estimating a project’s NPV, we can see whether the project is profitable. Despite NPV analysis is only based on financial aspects and it ignore non-financial information such as brand loyalty, brand goodwill and other intangible assets, NPV analysis is still the most popular way evaluate a project by companies.
The five investment appraisal techniques used for this report are the Accounting Rate of Return (ARR), payback period, Net Present Value (NPV), discounted payback and Internal Rate of Return (IRR). The results of the five investment appraisal techniques may not be similar because of differences in their approaches and calculations. However, it is advantageous to use more than one investment appraisal technique and understand the importance and problems of each method before making a final decision.
The use of an accounting rate of return also underscores a project 's true future profitability because returns are calculated from accounting statements that list items at book or historical values and are, thus, backward-looking. According to the ARR, cash flows are positive due to the way the return has been tabulated with regard to returns on funds employed. The Payback Period technique also reflects that the project is positive and that initial expenses will be retrieved in approximately 7 years. However, the Payback method treats all cash flows as if they are received in the same period, i.e. cash flows in period 2 are treated the same as cash flows received in period 8. Clearly, it ignores the time value of money and is not the best method employed. Conversely, the IRR and NPV methods reflect that The Super Project is unattractive. IRR calculated is less then the 10% cost of capital (tax tabulated was 48%). NPV calculations were also negative. We accept the NPV method as the optimal capital budgeting technique and use its outcome to provide the overall evidence for our final decision on The Super Project. In this case IRR provided the same rejection result; therefore, it too proved its usefulness. Despite that, IRR is not the most favorable method because it can provide false results in the case where multiple negative
NPV is a popular method to evaluate the investment decision of a new project. Most of the managers are most likely to use NPV for investment decisions. Whether, company invests in new project or improving the existing business process to achieve financial objectives of an organisation. Such as Randolph Mining Company have an extensive experience in mining industry. Still it is not easy to make a quick decision to built up the site or selling the right to the competitors with immediate benefit. In this situation, various analysis tools are more appropriate to better judgement of project. However, NPV is one of the most appropriate tool to predict possible future cash inflows from the project. It provides the time value of money components within the estimated project period. Therefore, director’s can easily make a decision based on positive cash generation from the desired project period.