Net Present Value

The globe is full of opportunities for businesses to invest in. Yet, resource constraints necessitate capital budgeting decisions, in which managers are responsible with selecting investments that provide the optimal return on shareholders’ equity. Managers utilize a variety of measures to assess the profitability of an investment, including the payback period, accounting rate of return, net present value, internal rate of return, and profitability index. Various methods have varied benefits and drawbacks, but the Net Present Value (NPV) is the most commonly used since it provides the absolute worth of the currency and can be used to analyze projects with variable cash flows. This report seeks to evaluate the Net Present Value (NPV) among others investment criteria.

Methods used to evaluate a project

There are different methods that can be used to evaluate a project. These are;

Payback period

Accounting Rate of Return

Net Present Value

Internal Rate of Return

Profitability Index (Ehrhardt & Brigham, 2016

The Net Present Value

The NPV method ranks investments using the present value of their future cash flows, discounted at the marginal cost of capital. The project that has a higher and positive NPV is regarded to be the most lucrative project to invest. The NPV is considered the most appropriate project evaluation method as it gives the absolute worth of a project, and tells the investor whether the chosen project is profitable or otherwise, and which project is more profitable than others. Additionally, it is the only method besides IRR that considers the time value of money. It also is unique in that it can be used to evaluate projects that have changing cash flows and discount rate, making it the most accurate in determining the true value of potential projects (Welch, 2014).

The IRR is a project evaluation method that ranks projects’ rates of returns by finding the discount rate that equates the value of the future cash inflows the cost of the project. When using the IRR evaluation method only investments, only projects that that produce and IRR figure than which is required can be selected. The IRR is closely related to NPV and is described as the discount rate that makes the NPV of an investment be equal to zero. Like NPV, IRR is an effective method to evaluate project as it also considers the time value of money (Stephen, 2017). Additionally, IRR is a good appraisal method as it provides an accurate figure of the associated risk of investing in the project and provides investors with the advantage of knowing the actual returns of their investments (Damodaran, 2015).

The Discounted Cash flow technique

John Whiteman , the senior portfolio manager at AMP Henderson can be considered skilled as he uses the discounted Cash flow technique to pick his stock, thus ensuring that the picked stock have the best rate of returns. The Discounted cash flow valuation technique calculates the intrinsic value of security based on its fundamentals. It is based on expected future cash flows of the company and the associated discount rate which is a measure of risk attached to the business (Rahman, 2015). DCF valuation technique makes an ideal way of picking stocks because it captures the underlying fundamental drivers of the firm i.e. the cost of capital, reinvestment rate and growth rate when estimating the intrinsic value of an asset (McGuigan & Moyer, 2012). Additionally, it relies on free cash flows, unlike other valuation methods. FCF eliminates the subjective nature of accounting policies and window dressing involved in reporting earnings. DCF technique also allows financial managers to incorporate fundamental changes in the business strategy that are not reflected in other valuation methods. Lastly, DCF valuation method acts as a sanity check to verify if the company’s stock is over-valued or undervalued (Brealey et al., 2015).

Question 5

The P/E ratio is calculated by dividing the market price of a share by the EPS thus to calculate the price per share we multiply the P/E ratio of 10 by the EPS of 108 cents to give $ 10.80 (10*108 cents).

The dividend yield describes the relation between the stock’s annual dividend pay and the stock’s market price. It is calculated using the formula: and is expressed as a percentage. In this case, the firm pays 65% of its earnings as dividends thus the annual dividend payout is 65%*108 cents=70.2 cents. The dividend yield is 0.702/10.80=0.065 or 6.5%.

The shares are bought at 1080 cents ($ 10.80) also the investor’s initial investment to earn a dividend of 70.2 cents hence the PBP is calculated as i.e. 1080/70.2= 15.38 which is approximately 15 periods (may be in form of years, months, etc) (Parrino, 2015).

The net book value per share of the asset investment in the company is calculated by i.e. 10.80/100= 0.108 where we use the ARR to calculate the company’s net income of 108 cents and the EPS to get the outstanding shares of 100.

Using the payback period of 15 years we can get the present value of the stock by discounting the dividend pay of 0.702 cents at the risk-adjusted rate of 6% then subtract the initial investment of $ 10.80 to get the NPV i.e.

Using the NPV evaluation technique I would not buy the shares. It has a –ve NPV meaning the PV of future cash flows are less than my initial investment. I have used NPV because it factors in risk and time value of money.

Conclusion

In retrospection, resource limitation calls on managers to choose investments that that ensure the best return on shareholders’ equity. There are different methods for thie evaluation, including them payback period, accounting rate of return, net present value, Internal rate of return and the profitability index methods. Of these, the IRR and the NPV are the most appropriate as they consider the time value of money while evaluating the value of a prospective project. Besides APV and IRR, there is the discounted cash flow valuation technique that is used to calculate the intrinsic value of security based on its fundamentals. All these techniques are geared towards ensuring that investors get the best value for their money.

References

Berk, J. B., & DeMarzo, P. M. (2017). Corporate finance. New York: McGraw-Hill/Irwin.

Brealey, R. A., Myers, S. C., Marcus, A. J., & McGraw-Hill Education. (2015). Fundamentals of corporate finance. New York: McGraw-Hill/Irwin.

Damodaran, A. (2015). Applied corporate finance. New York: McGraw-Hill/Irwin.

Ehrhardt, Michael C., & Brigham, Eugene F. (2016). Corporate Finance. South-Western Pub.

McGuigan, J. R., & Moyer, R. C. (2012). Contemporary corporate finance. Mason, Ohio?: South-Western, Cengage Learning.

Parrino, R. (2015). Corporate Finance. Singapore: John Wiley & Sons.

Rahman, N. (2015). Corporate Finance. North Ryde: McGraw-Hill Australia.

Stephen, R. O. S. S. A. (2017). Fundamentals Of Corporate Finance. New South Wales: Mcgraw-Hill Educ Australia.

Welch, I. (2014). Corporate finance. Los Angeles: Ivo Welch.