Net Present Value (NPV) - Free Paper Sample

Introduction

Net present value is defined as the average value of the future cash flows for a particular investment, which is, however, discounted presently. Major business organizations are utilizing NPV calculations to estimate their investment securities, capital projects, new ventures, cost reduction programs, and all other activities which relate to cash flows.

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The analysis of NPV is essential because it can be used to predict the worth of an investment or project. Besides, the computation of NPV includes all revenues, expenses, and all costs that are encountered when investing called Free Cash Flow (FCF). Also, the timing for all cash flows is taken into account. That is important because it is better to use the cash inflows at first, then later incur the cash outflows later on.

Usage of NPV

The central reasons why NPV is usually useed improvise the risks associated with an investment opportunity and to do accounting money value at different times (Time value of money TVM). For instance, more discount is usually given for the riskier investments, while less refund is given for less risky investments, or projects (Kimmel et al., 2018). Moreover, the determination of TVM is necessary because money usually changes its value over time. Probably, this could be affected by inflation and varying interest rates. So, $2million received today is likely to be worthier than $2million received later in 10years.

Before taking an example of NPV calculation, it is vital to note that NPV can be negative, positive, or zero. A positive NPV is obtained when the present value for the cash inflows is more than the cash flows. When making an investment proposal, such consideration will mean that the project is acceptable. A zero value of NPV denotes that the present value of cash inflows is the same as the present value of cash outflows. In this case, the project proposal is also acceptable. Lastly, a negative amount of NPV signifies that the present value of cash inflows is less than the present value of the cash outflows. This case discourages an investment proposal. The driving point of reference here is the discount rate. So, a negative value means that the expected rate of return is less than the minimum rate of return, and thus an investor will not accept it.

Capital Asset Pricing Model (CAPM)

The CAPM refers to a specific model that describes the connection between an investment's expected return value and the risks which are associated while investing in security. In a nutshell, the point driven here is that the value of an expected return when investing in particular security should be equal to the summation of the risk-free return and the risk premium that is primarily obtained from the beta of that specific security. The primary purpose of CAPM is to calculate the expected returns for an asset.

When determining the expected rates of returns for an asset, project, or investment, the central idea is based on the systematic risks. This can also get referred to as the non-diversifiable risks in which an investor may be willing to be compensated but in the form of risk premium. By definition, a risk premium simply denotes the return rate, above the risk-free rate. So, investors generally prefer to have a higher risk premium when dealing with riskier investment plans.

The Expected Return

The expected return, which is denoted by "Ra" is calculated after some time, using all the stated deliverables. It represents an assumption of what a particular investment will possibly return. The risk-free rate denoted by “Rrf” usually describes a total yield that can be obtained on investment for the U.S 10-year Federal bond. However, it varies depending on the country where an investment is being hosted (Kimmel et al., 2018). Besides, the final maturity of the bond must be the same as the stipulated time horizon for the investment.

The Beta represented by "Ba" typically shows the estimated stock's risk, which is measured by obtaining all the possible price fluctuations relative to the targeted market. Again, the value of beta can be negative, positive, or neutral (1). When it is 1, it means that the expected return for security is in level with the average market return. Negative beta value shows that the value of the security has a negative relationship or correlation with market returns. A positive value means that market volatility is higher than market returns. Finally, a market risk premium is an extra value obtained by deducting the expected return and risk-free rate. That additional return is used to compensate the investors who decide to invest in a hazardous business, project.

Weighted Average Cost of Capital (WACC)

WACC refers to the net average of the cost of all capital assets derived from significant sources such as ordinary shares, preferred shares, and debts. To determine the WACC, all distinct capital costs are weighted based on the average percentages of the total capital, and then summed together. The financial tool is often utilized by the modelers to calculate the NPV of a particular business accurately.

So, the significance of WACC is to assist financiers in predicting the exact cost of individual capital assets in the business, based centrally on their equities, debts, preferred stocks. All of these elements have respective costs in the company. For instance, any firm usually has fixed rates of interest on debts. Moreover, a fixed yield must be applied to the preferred shares (Kimmel et al., 2018. Even though there no evidence to support that companies typically apply fixed rates of returns on the common equities, there is perhaps enough justification that it often pays dividends by using cash, specifically to its equity holders.

It, therefore, means that WACC has an integral influence on discounted cash flows (DCF), making it a more substantial component of finance to study, especially when exploring matters of investment banking.

In the working formula for obtaining WACC, the cost of equity is calculated using the CAPM formula, which equated rates of return on security to risks related to the return. So, this also acts as an opportunity cost for a specific capital; or, the amount that shareholders are estimating theoretically that they should be compensated, or investing in a security. The second part of the calculation has the cost of debts and preferred stocks. Ideally, the cost of debt simply denotes the yield after the maturity of a particular debt, while the cost of preferred stock refers to the return after maturity of the stock. However, it is vital to understand that when making the calculation, the interests paid on debts are usually deductible, or instead taxable. To normalize this, the weighted costs of debts are multiplied by (1-tax rate), and that can be referred to as a tax shield. Nevertheless, that is not the case when dealing with preferred stock, because the obtained or average dividends are collected after considering all the possible tax profits. WACC can generally be useful when determining the discount rates for use in the NPV determination. Moreover, it may also be helpful when evaluating investment opportunities. Notably, it is the same WACC that companies rely on to get their hurdle rates, which can further help them in making merger or acquisition decisions.

Efficient Market Hypothesis (EMH)

EMH is an ideal financial market theory which postulates that asset prices have a direct impact on all available piece of information gathered. Going by the EMH hypothesis, both fundamental and technical analysis can't produce consistency when calculating the risk-adjusted additional return. Possibly, the hypothesis assumes that market prices must solely be applied to new information (Kimmel et al., 2018). The most effective EMH theory postulates that any new information in the market is customarily or automatically reflected in the stock prices; hence there is no need for an investor to participate in either technical or fundamental market analysis. By definition, technical analysis refers to the process of studying the past prices of market stocks, to gain an idea of future stock prices. Fundamental analysis refers to the process of studying financial information to gain an in-depth understanding and interpretation of the current stock prices.

Presumably, EMH further suggests that the indicated market prices usually include all the probable factors that could affect a product. Therefore, investors need no rationality to justify market prices. The theory can be divided into three segments, namely: strong, semi-strong, and weak EMH. For the weak EMH theory, it assumes that the current stock price reflects all the past information. However, an investor would be benefited from achieving beyond the market returns by doing fundamental analysis. The theory is only efficient for the short term. In the semi-strong EMH theory, both fundamental and technical analysis can offer an investor with no advantage on the market return but expresses confidence that any new information is priced alongside stocks. With the strong EMH, there is maximum confidence that new information, either public or private, is typically directed to the stocks. So, an investor will gain no advantage beyond the existing market return.

Conclusion

The theory has previously received challenges from three different proposal models: momentum investing, behavioral finance, and fundamental analysis. Momentum investing ideology combined both technical and fundamental analysis in suggesting that some price patterns usually persist over time. Behavioral financing believes that investors often utilize the principal philosophy to understand stock prices, rather than the ideal efficiency. Finally, the fundamental analysis posits that some valuation rations in the market could show outperformance or underperformance, especially in future dates. Meanwhile, the efficient EMH hypothesis has outshined all these models and maintains that stock prices are fixed and do not require further analysis.

Reference

Kimmel, P. D., Weygandt, J. J., & Kieso, D. E. (2018). Financial accounting: Tools for business decision making. John Wiley & Sons.
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