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New Approach to NPV

by Sandip De, Consultant: Business Analysis and Development at Ambidextrous on Jan 19, 2011

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Time Varying NPV

Time Varying NPV

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New Approach to NPVPresentation Transcript

• Capital Budgeting Decision Rules
• Net Present Value (NPV)
• Different Capital Budgeting Decision Rules
• Payback Period
• Average on investment Return Method
• Discounted Payback Period
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Modified Internal Rate of Return (MIRR)
• Profitability Index
• Cost Benefit Ratio
• Net Present Value (NPV)
• Definition
• The Net Present Value (NPV) of a project is the sum of the present values of all the cash flows – positive as well as negative – that are expected to occur over the life of the project.
• Where,
• C t = Cash Flow for t th Period
• t = Period instance of Project Life
• r = Cost of Capital
• n = Life of the Project
• Properties of NPV Rule
• NPV (A + B) = NPV (A) + NPV (B)
• Value of a Firm = NPV (Present Projects) + NPV (Future Projects)
• Intermediate Cash Flows are Invested at Cost of Capital
• The NPV rule assumes that the intermediate cash flows of a project – that is, cash flows that occur between the initiation and the termination of the project – are invested at a rate of return equal to the cost of capital
• NPV Calculation Permits Time Varying Discount Rates
• Discount rate Change with Time
• The discount rate may change over time for the following reasons:
• The level of the interest rates change over time and hence sheds light on expected rates in future.
• The risk characteristics of the project may change over time resulting change in cost of capital.
• The financing mix of the project may vary over time causing change in cost of capital.
• NPV using Time Varying Discount Rates Where, C t = Cash flow at the end of each period r j = One period discount rate applicable to period j (r 0 = 0) n = Life of the project α t = Certainty of Cash flow in percentage Risk Less Approach Certainty Equivalent Approach
• NPV using Time Varying Discount Rates
• These methods seeks to address a concern of predicting real returns and applying this predictability in the investment decision-making process.
• There are major problems in Valuation
• the market risk premium must be estimated,
• an appropriate risk-free rate must be chosen, and
• the beta of the project or company must be determined.
• All three of these inputs into are not constant.
• NPV using Time Varying Discount Rates
• These methods forecast the future cost of capital using trend analysis and probability on basis of expectancy of sure cash flow.
• These models can be further intervened for valuation of overseas by accounting the exchange rate exposure and global inflation.
• Limitations of NPV
• NPV is expressed in absolute terms rather relative terms and hence it does not give any picture of extent or scale of investment and what to choose, e.g.
• Project A; NPV 5,000,000; Investment 50,000,000
• Project B; NPV 2,500,000; Investment 10,000,000
• NPV rule does not consider the life of project as a measure of decision. Hence for mutually exclusive projects with different lives the rule becomes biased.