Net Present Value (NPV)

• Net Present Value (NPV) measures the value created by a business investment
• Managers use NPV to allocate capital among investment opportunities

NPV Basics

• NPV represents the difference between an investment's worth today and its cost
• Investing in projects where NPV > 0, helps maximize value
• Calculating NPV involves project definition, strategic analysis, risk assessment, financial analyses, execution planning, and performance assessments

Calculating NPV for a Single Risky Investment

• The net present value (NPV) is the present value (PV) of future cash flows minus the required upfront investment
• Estimate the present value (PV), is the more challenging aspect when calculating NPV
• The future cash flows come from the net after-tax operating cash flows that a business is expected to generate
• To compute the component of net present value (NPV), use this basic discounting method

Discount Adjustments

• Future business cash flows are risky, so it is important to regard the cash flow at a given future date as a random variable
• With risky cash flows, utilize the expected as the numerator in calculations
• Appropriately reduce value is by discounting riskier expected cash flows at a higher rate
• The discount rate must equal investors' required expected return on the proposed investment
• Investors want greater rates of return on riskier investments
• Include a risk premium in the risk-adjusted discount rate represented by the formula k = r + risk premium

Pharmaco, Inc. Case

• Pharmaco, Inc. considered buying rights to sell a new drug created by R&D Ltd for $1 billion
• The drug generates 150millioninYear1,growingat20150 million in Year 1, growing at 20% yearly for four years with a 150millioninYear1,growingat20500M terminal value in Year 5
• With a 4% risk-free rate and an 8% opportunity cost of funds, Pharmaco should decide about buying the rights using NPV
• One can calculate using each at k = 8% for the indicated number of periods
• NPV = 1,207million−1,207 million - 1,207million−1,000 million = $207 million
• Employees have a lot to do to make the operating projections come true, and calculation includes this in the present value
• Treasury bonds cannot be used as a benchmark for k as they are risk free

Interactive Illustrations

• A simple NPV calculator to show how factors affect NPV and a change in the discount rate

Alternatives to NPV

• The two most common investment metrics companies consider are internal rate of return and payback period

Internal Rate of Return

• IRR is the discount rate at which its NPV equals zero
• Compute the IRR for a project and base a “go or no-go” investment decision on it rather than on the NPV
• It is the best metric if IRR is greater than the risk-adjusted discount rate and NPV is more than 0
• When the sign of annual cash flows, whether positive or negative, changes more than once during the life of a project, there might be multiple IRRs

Project Cash Flow

• If a project has no outflows, just cash inflows then IRR doesnt exist
• One must ignore irrelevant IRR and compare the positive IRR to the required return
• In the case of cash inflow(s) followed by later cash outflows, the IRR rule has to be reversed
• The IRR is best when a typical "conventional" pattern is expressed

Payback Period

• Its the length of time it takes to recover the original investment in a project
• Accept a project if its payback period is less than a target length of time

Drawbacks

• The is no economic basis on which to choose the targeted payback length, or "hurdle."
• The payback calculation overlooks all cash flows after the initial outlay has been recovered

Improving PayBack Period

• Practitioners can refund by discounting the cash inflows before adding to compute the payback period
• The original investment or NPV are all computed in today’s dollars
• The discount rate k is a summary measure of risk and the time value of money

Choosing Investments

• Investment decisions are assessed through returns or values
• If the expected return on a project exceeds its required expected return, then invest

Required Expected Return

• By setting the discount rate equal to the required return, we obtain the price we would be willing to pay for it
• In effect, it may be very hard to estimate expected future cash flows, especially if the real option happens to be embedded within another otherwise conventional project
• All investments plotting above the line have NPV > 0 and capital market matters

Hurdle Rates

• Companies must decide if all projects' NPVs be computed using a companywide rate, or should each project receive a different rate
• Appropriate risk-adjusted rate k has to be different for two projects if one was riskier than the other
• Value maximization requires that the risk-adjusted discount rate k equals the opportunity cost of funds

Investment Errors

• The treasure should not be good (or very lucky ) at raising funds cheaply say 3%
• When a firm uses a single hurdle rate all the time, its easy for them to make investment mistakes
• The single rate leads to having good but rejected projects and mistakes about negative investment
• Some projects show a dependence and the simple capital is that is how the large number or managers make profits