Essay About Present Value And Discounted Cash-Flow Basis

Npv Analysis
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48 Competitive Intelligence Magazine
Within the broad category of
finance, there are many tools and
techniques available for use by
competitive intelligence (CI)
professionals to analyze the general
financial health of a company and its
competitors. Whether your firm or your
client might be considering such things
as mergers & acquisitions (M&A)
analysis or project valuation, net present
value (NPV) analysis is a very simple
tool that can be used with great
benefits.
WHAT IS NPV ANALYSIS?
The net present value of an
investment is:
* the value an investment must
represent today
* on a discounted cash-flow basis
* to make an investment worthwhile
after taking into account the cost of
the investment
Discounted cash flow numbers are
arrived at by estimating the cash flows
in your future scenario, and adjusting
them to a value they represent today
based on some predefined discount rate.
The NPV is the sum of the discounted
cash flows minus the cost of the
investment. If the NPV is positive, the
investment is worth taking on because
it is essentially the same as receiving a
cash payment equal to the NPV.
NPV ANALYSIS AND APPLICATIONS FOR
COMPETITIVE INTELLIGENCE
DEREK JOHNSON, Aurora WDC
Conversely, if the NPV is negative,
taking on the investment dilutes the
firms value and should be rejected. But
first, lets discuss how to arrive at
appropriate discount rates and calculate
a firms Weighted Average Cost of
Capital (WACC).
WHAT IS THE APPROPRIATE
DISCOUNT RATE?
The choice of discount rate to use
in your NPV analysis can have serious
impact on results and there are several
different ways to arrive at an
appropriate discount rate. As a general
rule, you should use a discount rate that
matches the way in which your firm is
financed.
If a firm were entirely financed
with equity, the most appropriate
discount rate to use would be the
required return to equity required by
shareholders. A more realistic notion is
that the firm in question is financed
with some allocation of debt and equity,
in which case using the firms WACC is
most appropriate.
WEIGHTED AVERAGE COST OF
CAPITAL
You can calculate the WACC if you
have the firms equity and debt market
values, the cost of equity, the cost of
debt, and the firms corporate tax rate.
If your competitors are public
companies, this information is in their
public financial statements. If your
competitors are private companies, (as
is often the case), finding these figures
often requires primary research.
Suppose your firm has a market
value of $1 billion and is currently
operating at its target debt/equity ratio
of 33.3%. These values indicate total
debt of $250 million and total equity of
$750 million. Continuing further,
suppose that the firms cost of debt is
12% and the required return to equity
shareholders, which can be calculated in
several different ways, is 15%. Finally,
the firm has a corporate tax rate of
34%. The WACC returned to us in this
calculation is 13.23%. (See Table 1.)
HOW IS NPV CALCULATED?
The NPV is the sum of the
discounted future cash flows less the
cost of undertaking the project. For
example, if Firm A wants to acquire
Firm B for $50 million and expects
Firm B to produce cash flows of
15,000,000, 20,000,000, and
27,500,000 at the end of each of the
next three years, the NPV of the
investment