S6: Corporate Finance: Net Present Value

Net Present Value (NPV) is the difference between the investment’s market value (in today’s dollar) and its cost (in today’s dollar). this shows us that how much is created by undertaking an investment. estimating the future cash flow and the discount rates are important in the calculation of the NPV.

Steps in the calculation of the NPV

1. Calculate the Future Cashflow
2. estimate the discount rate
3. find the present value of the cash flow and subtract the other initial investments.

the main criteria for a project:

if the NPV is positive the project should be accepted and if negative, it should be rejected.

Payback Period:

an amount of time that investment can generate the cash flow to recover its initial cost. it is an easy concept to understand, but we are ignoring the risk.

Discounted payback period:

it is similar to the one before, but here we use discounting so we take the risk into our calculations.

Advantages:

• Includes time value of money
• Easy to understand
• Biased toward liquidity
• Doesn't accept negative estimated NPV investment

Disadvantages:

• May reject Positive NPV investments
• Arbitrary determination of acceptable payback period
• Ignores the cash flow beyond the cutoff date (In accounting, the cutoff date is the point in time that delineates when additional business transactions are to be recorded in the following reporting period. For example, January 31 is the cutoff date for all transactions that will be recorded in the month of January)
• biased against long term and new products

internal rate of return (IRR)

this method is strongly connected to the amount of the PV of future cash flow and the PV of the costs. the condition for acceptance of the project is that the IRR> the required rate of return. and the higher the IRR, is better for our project.

IRR is the calculated rate at which the NPV is zero.

The main problem:

1. multiple rates of return:

there can be different solutions for the case that NPV is equal to zero. to solve this issue we can use the adjusted cash flow.

2. Mutually exclusive projects:

we should consider several investment criteria when making the decisions.

NPV and IRR are the most commonly used criteria and the payback period is the secondary method.