Net Present Value (NPV)

Subject: Advanced Management of Technology

Student name: Subhan Ullah

Student ID: D135117
 Chapter Outline
Net present value
The separation principle
Estimating free cash flows
The weighted average cost of capital
The time pattern of net present value
Certainty-Equivalent approach to the net present value
Empirical evidence
Conclusion
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 Net Present Value
Net present value is the single most widely used tool for large
investments made by corporations.
Klammer reported a survey of over 100 large companies
indicating that in 1959 only 19 percent used NPV techniques,
but by 1970, 57 percent used them.
Roughly a decade later, Schall, Sundem, and Geijsbeek
sampled 424 large firms and found that 86 percent of those
responding used NPV.
It took over two decades for NPV to be widely accepted.
Undoubtedly, this rate of adoption was affected by the
introduction of pocket calculators and desktop personal
computers.
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How to estimate the Net Present Value
How much value is created from undertaking an
investment?
Step 1: Estimate the expected future cash flows.
Step 2: Estimate the required return for projects risk
level.
Step 3: Find the present value of the cash flows and
subtract the initial investment to arrive at the Net
Present Value.
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Net Present Value - Sum of the PVs of all cash
flows

n CFt
NPV =
(1 + R)t
t=0

Initial cost often is CF0 and is an outflow

n CFt
NPV = t
- CF0
(1 + R)
t=1

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 NPV Decision Rule
If NPV is positive, accept the project
NPV > 0 means:
Project is expected to add value to the firm
Will increase the wealth of the owners

NPV is a direct measure of how well this project will

meet the goal of increasing shareholders wealth.

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 Sample Project Data
You are looking at a new project and have estimated the following
cash flows:

Year 0: CF = -165,000
Year 1: CF = 63,120
Year 2: CF = 70,800
Year 3: CF = 91,080

Your required return for assets of this risk is 12%.

NPV = -165,000/(1.12)0 + 63,120/(1.12)1 + 70,800/(1.12)2 +

91,080/(1.12)3 = 12,627.41
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 The separation principle
Simply stated, the separation principle is the useful result
that shareholders of a firm will agree about the decision
rule they want managers to execute on their behalf
namely to undertake investments until the marginal return
on the last dollar invested is smaller than or equal to the
market-determined opportunity cost of capital.

This is a critical keystone in the theory of decision making

because we do not have to construct a complicated rule
for the managers that requires that they acquire and use
individual owner (shareholder) preferences.
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 Utility Total utility and
Marginal utility

The indifference curves

represent a theory of
choice

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 Marginal rate of
substitution
The slope of the line tangent to
an indifference curve shows the
rate of exchange between
consumption today and
consumption at the end of the
year.

The investor always requires

extra units of consumption
tomorrow in return for giving up a
unit of consumption today.
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 The marginal rate of transformation focuses on
supply and the marginal rate of
substitution focuses on demand.

The marginal rate of transformation is the rate at

which one good must be sacrificed in order to
produce a single extra unit (or marginal unit) of
another good, assuming that both goods require
the same scarce inputs.

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Production opportunity set

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 At point B Marginal rate of
substitution equals his
marginal rate of
transformation.

He will decide to remain at

point B, where he consumes C0*
today and C1* at the end of
the period, and invests 0
(C C *
0)
today.
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 C1
W0 C0
1 r

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 Note that the production output at point B, which
is where the market line is just tangent to the
production opportunity set, provides him with the
greatest feasible wealth, 0 .
W *

It also provides him with the highest possible total

utility, because he will produce the output at point
B, then borrow against it at rate r to reach point C,
*
a bundle of consumption with wealth 0 . W

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 At point C, his marginal rate of substitution is the
slope of the market line [ i.e., - (1 + r)].

Also, the same market line is tangent to the

production opportunity set at point B.

Therefore, if he maximizes his wealth, and his total

utility, he will choose to produce the combination at
point B, then borrow to move to point C.

At point C, his marginal rate of substitution equals the

slope of the market line, which in turn equals his
marginal rate of transformation.
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 This section is concluded by
illustrating the separation principle.
This separation principle means that
the wealth-maximizing rule for
investment is separate from any
information about individual utility
functions

Therefore, all individuals, regardless of

their time preferences for consumption
today versus consumption tomorrow,
will choose to invest until the marginal
rate of return on the last unit of
investment is just equal to the market
rate (at point B)
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 Free cash flow (FCF)
Free cash flow (FCF) is a measure of a
company's financial performance, calculated
as operating cash flow minus capital expenditures.

FCF represents the cash that a company is able to

generate after spending the money required to maintain
or expand its asset base.

FCF is important because it allows a company to pursue

opportunities that enhance shareholder value.
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 Specifically, FCF is calculated as:
EBIT (1-tax rate) + (depreciation) + (amortization) - (change in
net working capital) - (capital expenditure).

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Weighted average cost of capital (WACC)
Weighted average cost of capital (WACC) is a calculation of
a firm's cost of capital in which each category of capital is
proportionately weighted.

All sources of capital, including common stock, preferred

stock, bonds and any other long-term debt, are included in a
WACC calculation.

A firms WACC increases as the beta and rate of

return on equity increase, as an increase in WACC denotes a
decrease in valuation and an increase in risk.
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 The weighted average cost of capital is estimated as;

B S
WACC kb (1 T ) ks
BS BS
500 750
.10(1 0.5) .30
500 750 500 750
.02 .18 20%

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Time pattern of net present value

Project with a finite life

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Certainty-equivalent approach to net present
value
It is possible to estimate the value of a project either by
taking its expected future free cash flows and
discounting them at a risk-adjusted weighted average
cost of capital, or to risk-adjust the cash flows and
discount them at the risk-free rate.

The certainty-equivalent approach is a common method

for valuing options in a lattice.

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 Consider a simple one-period example.
A projects expected cash flows are $1,000, the risk-free
rate is10 percent, the expected rate of return on the
market is 17 percent, and the projects beta is 1.5.
If it is an all-equity firm, then its present value is;

E ( FCF )
PV
1 R f [ E ( Rm ) R f ] j
$1, 000 $1, 000
$829.88
1 .10 (.17 .10)1.5 1.205
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 If the investment outlay is $800, then its net present value is
NPV = PV I = $829.88 - $800 = $29.88

COV ( R j , Rm )
j
VAR( Rm )

FCF PV FCF
Rj 1
PV PV
FCF
COV 1, Rm
PV 1 COV ( FCF , Rm )
j
VAR( Rm ) PV VAR( Rm )
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 E ( Rm R f ) VAR( Rm )
is the market price of risk of risk in
the capital asset pricing model.
This approach adjusts for risk by subtracting a penalty
from expected cash flows to first obtain certainty-
equivalent cash flows, then it discounts them at the risk-
free rate.
$1,000 - $87.13 = $912.87
$1, 000 E ( FCF )
PV $829.88
1.205 1 risk adjusted rate

$912.87 E ( FCF ) risk premium

PV $829.88
1.10 1 riskfree rate
That we can obtain the same answer using either a risk-
adjusted or a risk-neutral approach. 28