Net present value is a measure of how much value could be added to an initial cash outflow by undertaking an investment. It is the difference between project’s market value and its cost. NPV accounts for the time value of money by expressing future cash flows in terms of their value today. It recognises that money has a cost (interest), so that one would prefer to have a certain amount of money, say £10 today to having £10 a year from now. If there is an interest rate of 20% when the money is invested, £10 today will be worth £12 a year from now. In other words the present value of £12 in one year is £10.
When talking about corporate finance, managers’ decisions are based on the fact that the goal of a firm is to maximise the market share price and therefore increase the wealth of its shareholders. Fisher’s separation theorem states that in perfect capital market, maximising share price makes shareholders better off. NPV is preferred approach used by many firms because although all shareholders are different and have different preferences, if a firm uses NPV it will benefit everyone. A project should be accepted if its NPV is positive because the present value of cash inflows is greater than the present value of cash outflows and the project is profitable. If an investment has a negative NPV it should be rejected, because it will decrease shareholders’ wealth. “If being careful, managers should add the caveat that a positive recommendation to take a project should only be made if taking on the project doesn’t prevent them from undertaking some other project.” (Ross, 1995) If two projects are mutually exclusive, taking on one will prevent managers from undertaking another one. This can be seen as an opportunity cost of the project, which will be undertaken. Furthermore, NPV tells us whether a particular project is worth investing into and also lets us compare various projects and pick the one that will increase shareholders’ wealth the most.
However, the NPV approach has its problems. Firstly, it is very difficult to come up with the future cash flows and the discount rate. We can only estimate these and there is no guarantee that the estimates and therefore the NPV will turn out to be correct. This is especially hard if the interest rate is very volatile.
Traditional way of calculating NPV is to use discounted cash flows. However, discounted cash flow approach to NPV rule does have its problems as well. “As Arya, Fellingham and Glover (1998) have pointed out, the standard NPV rule implicitly makes two assumptions which are often overlooked. First, the project approval decision (if the project is turned down it cannot be undertaken in the future) and that real option to defer, expand, contract, abandon, switch use or alternatively alter a capital investment can be ignored. Second, decisions are made either in a single person firm or in a multi-person in which there are no information asymmetries between the firm’s owners and managers (or between managers), and each member is motivated to the same objective.” (Arnold, Hatzopoulos, 2000) NPV doesn’t allow managers to defer projects and can therefore lead to incorrect decisions. For example, if current interest rate was 15% and a year later it fell to 10%, it would mean that taking on the project in one year would lead to higher NPV and therefore increased wealth.
One of the alternatives to NPV is the Payback period rule. Managers select a particular cut-off period and all the projects that recover invested capital within this period are accepted. All projects that recover the invested capital in more than the specified period are rejected. One of the most obvious advantages of this approach is simplicity. Payback rule is mainly used for small investment decisions that are, mainly in large organisations, made very often. Small companies tend to use it because it favours short-term projects that free up capital quickly. And because it favours short-term projects, it also favours liquidity. For the same reason it is easier to assess the manager’s ability in decision making. With NPV approach, the investments tend to be long term and often managers leave before the project is completed.
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Net present value
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