Net present value

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.
The payback rule is not the same as the NPV and is therefore conceptually wrong. With its arbitrary cut-off date and its blindness to cash flows after this date, it can lead to some foolish decisions if it is used too literally.” (Ross, Westerfield, Jordan, 1995) One of the disadvantages of payback rule is that it ignores cash flows that occur after the cut off period as opposed to NPV, which uses all the cash flows of a project. The bias towards liquidity can lead to decisions that are not in the best interest of the shareholders. Quite often a project is accepted because it recovers initial investment before the cut off date but if a NPV analysis was carried out, the NPV would be negative. Therefore, NPV approach and Payback rule can lead to conflicting decisions. Also the payback period rule does not consider the timing of the cash flows and therefore ignores the time value of money. It assigns more value to early cash flows. “The biggest drawback to the payback rule is that it does not ask the right question. The relevant issue is the impact an investment will have on the value of shares, not how long it takes to recover initial investment.” (Ross, Westerfield, Jordan, 1995) However, using the discounted payback rule can eliminate most of the disadvantages of payback rule.

The most important alternative to NPV is the internal rate of return, abbreviated IRR. IRR attempts to find a single rate of return that summarises the value of a project. The meaning of “internal” in this approach means that the rate only depends on the cash flows of a particular investment, not on rates defined by the capital market. A project is accepted if IRR is greater than the required return. Therefore accepting a project with the discount rate smaller than the IRR is equivalent to accepting a project with positive NPV. IRR of an investment is the discount rate that makes the NPV equal to zero.

IRR and NPV should lead to the same decision, nevertheless, two conditions need to be satisfied. Firstly, cash flows of a project must be conventional, meaning that the initial cash flow is negative and all the subsequent ones are positive. Secondly, the project must be independent of any other projects, which means that accepting or rejecting it will not have an influence on accepting or rejecting any other project. Problems could arise when the cash flows are not conventional. “Descarte’s rule of sign says that the maximum number of IRRs that there can be is equal to the number of times that the cash flows change sign from positive to negative and/or from negative to positive.” (Ross, Westerfield, Jordan, 1995) If the NPV of a particular project is negative at every discount rate, there will be no IRR.
The advantage of IRR over NPV is that it is easier to understand and communicate. It is difficult to estimate NPV without knowing the appropriate discount rate, whereas IRR doesn’t require the use of a capital market discount rate.

When companies are making decisions about major investments, it is probably more useful to employ either NPV rule or the Internal rate of return. For smaller projects or decisions, it may be easier and less costly to use the payback period rule. However, research suggests that there are a large number of firms using the payback rule and its popularity has been growing in the past 20 years. Study carried out by Pike and Wolf shows that out of 100 large firms in the UK 73% were using the payback rule. This number rose to 94% in 1992. One of the reasons is that firms prefer short-term projects and they need returns as soon as possible to start new projects. Also many small firms have budgets and the sooner they accumulate cash the better.