Review: Net Present Value

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Review Net Present Value

• Presentation by
• Heather Collins Michael Maur

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Agenda

• Capital Budgeting - why we use NPV
• Value of Money Over Time
• Net Present Value
• Investment Decisions
• The Discount Rate
• Example
• NPV vs. IRR

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Capital Budgeting

• Analysis of potential additions to fixed assets.
• Long-term decisions, involve large expenditures
• NPV is a tool used in capital budgeting, along
  with IRR.
• Types of projects
• Brand new line of business
• Expansion of existing line of business
• Replacement of existing asset
• Independent vs. Mutually Exclusive

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Value of Money Over Time
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Value of Money Over Time

• A different point of view
• An investment promises to yield a 1M one-time
  profit, one year from now
• How much of todays dollars am I willing to pay
  today to have 1M in a year?
• p_max 1M/(1r)
• r is the discount rate
• p_max is the Net Present Value (NPV)

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Net Present Value

• Net present value a projects net contribution
  to wealth present value minus initial
  investment.
• In other words, the present Value in "today's
  dollars" of the future net cash flow of a project
• NPV PV cash inflows - PV cash outflows

t
1 C1
2 C2
3 C3
n Cn
0 today C0
. . .
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Using NPV to Make Decisions

• r rate of return of alternative investment
• NPV gt 0 Investment promises additional returns
• NPV lt 0 Investment will yield less return than
  alternative investment
• NPV 0 Investment will yield an equal return to
  an alternate investment
• As a general rule of thumb, choose project with
  higher NPV

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Discount Rate

• How does the management team determine a
  reasonable discount rate?
• What information do they use to estimate it?
• How do they account for future changes?
• What are some possible bias?
• Interest that can be earned from an alternative
  investment
• Incorporate adjustments for
• Inflation
• Risk - specifically the risk that the expected
  cash flows will not be the actual cash flows

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Discount Rate

• Other factors that can be used to estimate the
  discount rate
• 30 year treasury bond rate
• Investment Funds target rate of return
• Consumer Price Index (CPI)
• Max of highest risk-adjusted rate of return that
  can be obtained by investing the money lowest
  rate at which money can be borrowed
• Average cost of capital in the company

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Review Types of Annuities

• Ordinary (immediate) annuity
• The payments are made at the end of each period
• Annuity due
• The payments are made at the beginning of each
  period
• If the cash flows are an annuity due instead of
  an ordinary annuity, it changes the NPV.

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Review Types of Annuities

• The NPV changes because the number of periods
  that each CF is discounted changes.
• If it is an ordinary annuity, the January payment
  would be made on January 31, and thus discounted
  once. If it is an annuity due, the January
  payment would be made on January 1, and not
  discounted.
• i.e. annuity dues end up discounted one less
  period than ordinary annuities, thus the NPV
  changes.

t
Feb
Mar
Apr
n
Jan
. . .
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Review Types of Cash Flows

• Normal vs. Non-normal Cash Flows
• Normal Cost (negative CF) followed by a series
  of positive cash flows - one change of signs.
• Non-normal Cost (negative CF), a series of
  positive cash flows, cost to close project -
  two or more changes of signs.

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Example Marges Decision

• Calculator Steps. Falafel-Full CF0 -20,000,
  C01 15,000, F01 2, C02 13,000, F02 1, C03
  3,000. NPV I 12, CPT NPV 16,510
• Pretzel CF0 -20,000, C01 2,000, C02 2,500,
  C03 3,000, C04 50,000. NPV I 12, CPT NPV
  17,690

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Example Marges Decision

• If projects are independent, Marge should select
  both.
• Both have positive NPV.
• If the projects are mutually exclusive, select
  How Bout A Pretzel?
• Pretzel NPV gt Falafel NPV.

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Three Things to Remember

• The NPV rule recognizes that a dollar today is
  worth more than a dollar tomorrow
• NPV depends solely on the forecasted cash flows
  from the project and the opportunity cost of
  capital.
• Better than other investment rules that depend on
  choice of accounting method, profitability of
  existing business, etc.
• Because present values are all measured in
  todays dollars, you can add them up.
• NPV (A B) NPV (A) NPV (B)

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NPV vs. IRR

• The next group will go over IRR, however, NPV and
  IRR sometimes rank projects differently.
• Size differences smaller projects free up funds
  at t0
• Timing differences projects with faster payback
  provides more CF in early years for reinvestment.
• Reinvestment Rate Assumption
• NPV assumes cash flows are reinvested at
  companys cost of capital (i.e. the investors
  required rate of return).
• IRR assumes cash flows are reinvested at IRR.
• The NPV reinvestment rate assumption is more
  realistic.
• Why? Because NPV represents the investors
  required rate of return and corporations should
  act to maximize shareholder wealth.

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Review Net Present Value

• Thank you for your attention!
• Any Questions?