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How Investors Use The Net Present Value

Hope-based investing is not working most of the times, and there are so many failed acqusitions to prove this. Evaluating and analyzing potential investments is a science and it has its own tools. This is what we are going to discuss next.

Overpaying for underperformance

In 2000   AOL announced the largest corporate acquisition in history working with Time Warner media conglomerate in a transaction valued at $164 billion. The deal was finalized in 2001. As it turned out it proved to be the worst acquisition history as it became clear in time that AOL wildly overpaid for the acquisition, and the merged company ended up writing off over $100 billion of the purchase price.

Why didthis happen? Well, while some might point to difficulties in integrating the companies or a failure to achieve certain projected growth economies of scale or cost cuts, the answer essentially comes down to a simple proposition: in most cases the acquirer simply pays too high a price for what it is getting in return, even if the price payed is the same as any other aquirer would pay.

Value created must exced acquisition costs

When companies are considering potential investment opportunities whether the acquisition of another company or even the acquisition of a piece of equipment or real estate how should they evaluate and analyze these potential investments. Basically we need to earn more from investment over time than we pay for.

Clearly the objective of any investment should be to create value. But what does value mean in simplest terms? Simply, value is created when the future benefits arising from an investment exceed the amount invested.

In general we know what investment is going to cost us since we usually pay for it upfront but the returns or cash flows from investment come back to us at some future point in time and those future cash flows are worth less because of the time value of money which we discussed in earlier lecture.

Evaluating investment opportunities

There are several different approaches used for evaluating investment opportunities:

  • the Payback Method;
  • the Accounting or Book Rate of Return, and
  • the Net Present Value or NPV for short.

The payback method

The payback method essentially answers the following question: if I make an investment of X dollars today how long do I have to wait until I recoup my investment? For example if I invest $10,000 and I expect the investment to earn $1000 each year after taxes the payback period would be 10 years. All else equal the shorter the payback period the better the investment opportunity of course.

The payback approach is widely used because it is fairly simple, easy to apply and relatively intuitive. We all may have some sense that if we invest in something a payback within a few years would generally make sense and ultimately prove to be a good investment. On the other hand there are some serious deficiencies in the payback approach.

After all the goal of any investment is not just to get your money back to generate a return of your investment but to actually make a profit, to generate a return on your investment. The payback method, while popular, ignores cash flows after the payback period and ignores the time value of money. Moreover the maximum acceptable payback period is usually arbitrary reflecting some policy decision established in the past.

Accounting or book rate of return

Much of the focus is on the income statement especially revenues, net income and earnings-per-share. Cash flows, while certainly important, are usually not given as much emphasis in quarterly and annual earnings releases. As a result some financial managers might use book accounting data to assess and evaluate investment opportunities instead of cash flows contrary to what finance theory tells us they should be doing.

For example, imagine a company operating at capacity that was considering a $10 million investment in new and more efficient machinery which would increase productivity and create value for the company and its shareholders. The current machinery while definitely outdated is still functional and in use.

Further, assume that this old machinery and this is important has been fully depreciated and therefore has no value on the company’s balance sheet. If the CFO are strictly looking at an accounting ROI any return that the old machines produce would appear to be infinite. That is , the income generated by the machines would be made on something with no accounting value the depreciated machines.

Net Present Value

However this above mentioned method is a flawed approach because it is based on financial accounting metrics which include non-cash depreciation expense. This is cause for a significant difference between the accounting value of the equipment under generally accepted accounting principles and it’s true economic value which should be based on actual cash flows and true market values.

Therefore, it is imperative that we look at cash flows and not financial accounting metrics to determine whether an investment might be value creating. So, we need a more robust and more reliable and more effective means to evaluate the investment opportunities in the payback or counting rate of return approaches and net present value fits.

To put it simply, the net present value is the sum of all the individual outflows and or inflows related any investment with each of the individual cash flows discounted to its present value.  In other words we say that the net present value equals the present value of all future cash flows over time less the amount of the initial investment.

General rules and principles

Now that we have worked through a simple but practical example let me mention some general rules and concepts that are important when we calculate the net present value of any investment opportunity:

    1. sensitivity analysis is important, any quantitative models output is only as good as the inputs. Obviously any investment model requires predictions about the unknown and uncertain future so it is important that we put together what if scenarios perhaps best worst in best case scenarios for any investment we are considering;
    2. cash flows are normally the relevant thing to discount for most organizations and not just any cash flows but after-tax cash flows, not accounting profits or some other measure granted this may require us to make some assumptions about the tax rates will have to pay both today and in future years but we should at least consider them;
    3. these concepts can in fact apply to philanthropic organizations as well those entities who are not so concerned about cash flows generated by their investments but about the achievement of some other outcomes. For these organizations the concepts embedded in net present value are just as relevant.
    4. when applying the net present value formula we should consider only incremental cash flows in the numerator of our formula.

    5. we must treat inflation consistently, that is our projected cash flows should be nominal and not discounted for inflation after all that is the whole point of discounting to put future nominal cash flows into today’s dollars. if we put the future cash flows in today’s dollars and then discount them for inflation that would essentially be double counting.