Corporate Finance

 NPV and definition

Net Present Value (NPV) is the value of all future cash flows (positive and negative) over the
entire life of an investment discounted to the present. NPV analysis is a form of intrinsic
valuation and is used extensively across finance and accounting for determining the value of a
business, investment security, capital project, new venture, cost reduction program, and anything
that involves cash flow.

The formula for Net Present Value is:

Where:

Z1 = Cash flow in time 1

Z2 = Cash flow in time 2

r = Discount rate

X0 = Cash outflow in time 0 (i.e. the purchase price / initial investment)

Why is Net Present Value (NPV) Analysis Used?

NPV analysis is used to help determine how much an investment, project, or any series of cash
flows is worth. It is an all-encompassing metric, as it takes into account all revenues, expenses,
and capital costs associated with an investment in its Free Cash Flow (FCF).

In addition to factoring all revenues and costs, it also takes into the account the timing of each
cash flow that can result in a large impact on the present value an investment. For example, it’s
better to have cash inflows sooner and cash outflows later, as opposed to the opposite of that
ADVANTAGES OF NPV

 ASSUMPTION OF REINVESTMENT
Unlike IRR, using NPV makes sense because it does not assume that the cash flows will be
reinvested at IRR which is almost impossible. How can your cash flows get reinvested at the
project’s rate of return? Reinvesting the cash flows at IRR would mean you are investing back
the cash flows from your project into the market at the equivalent rate as that of your project’s
rate of return. You need to find another investment yielding same as your project for the
reinvestment. Well, that’s really difficult.
 CONSIDERATION OF ALL CASH FLOWS
NPV takes into account each and every cash flow you define. It’s not like payback period
method or discounted payback period method which ignores cash flows beyond the payback
period.
 GOOD MEASURE OF PROFITABILITY
If you wish to choose one single project from amongst many then NPV will be a good measure
of profitability. If you use IRR for mutually exclusive projects you might end up selecting small
projects with higher IRR and of a short-term nature at the expense of long-term (long-term value
creation is good for shareholders) and higher NPV projects.
 FACTORS RISKS
Discount rates are used in calculating NPV; the risk of undertaking the project (Business risk,
financial risk, operating risk) gets factored into this method.

DISADVANTAGES OF NPV

 ESTIMATION OF OPPORTUNITY COST

Determining the opportunity cost might become difficult. This opportunity cost is especially
considered in the initial outlay. Therefore, underestimating the initial outlay will distort the
result.

 IGNORING SUNK COST

In capital budgeting world sunk costs (costs incurred before you start a project. E.g. – R&D
costs) are not included. Hence, these costs might be huge and ignoring these costs might
sometimes become very difficult for the corporate finance team.

 DIFFICULTY IN DETERMINING THE REQUIRED RATE OF

RETURN
Determining the rate at which the cash flows are to be discounted might be tough for the
corporate finance team. A firm should not use WACC as the rate but must use the project’s rate
of return as a discount rate and thus the wrong estimation may lead to higher or lower NPVs.
Remember, a high-risk project should not be discounted at its cost of capital but at its required
rate of return.

 OPTIMISTIC PROJECTIONS
Sometimes managers are too optimistic about the success of the project and since the corporate
finance team needs to sit with the management to take into account the business scenario of the
project; the cash flows considered might be too high. Hence, there can be an upward bias with
respect to this method.

 MIGHT NOT BOOST EPS AND ROE

Short-term projects having higher NPV might not boost the Earning per share, Return on equity
of the company. EPS and ROE is what will increase the shareholder value. Short-term projects
with higher NPV might not work in shareholders favor.

DIFFERENCE IN SIZE OF PROJECTS

Capital rationing is where you don’t have access to unlimited funds and so you have to choose
projects within your capital budget. Now, for a mutually exclusive project comparing the NPV
of the projects that require a different amount of funds will not be suitable. For e.g. – (assuming
your capital budget is $7 million) Project A requires $10 million and produces an NPV of $2
million and there is a project B which requires $5 million and produces an NPV of $0.5 million.
In this case, the NPV of project A and project B can’t be compared for the decision making
process since the size of the 2 projects are different

 CONCLUSION
Regardless of its disadvantages, finance managers widely use NPV and they consider it as a good
measure of profitability than IRR, discounted payback period and payback period

 IRR and its concept

The internal rate of return (IRR) is a metric used in capital budgeting to estimate the
profitability of potential investments. The internal rate of return is a discount rate that makes
the net present value (NPV) of all cash flows from a particular project equal to zero. IRR
calculations rely on the same formula as NPV does.
Formula and Calculation for IRR

It is important for a business to look at the IRR as the plan for future growth and expansion. The
formula and calculation used to determine this figure follows.

IRR=NPV=t=1∑T(1+r)tCt−C0=0

where:

Ct=net cash inflow during the period t

C0=total initial investment costs

r=the discount rate, and

t=the number of time periods

To calculate IRR using the formula, one would set NPV equal to zero and solve for the discount
rate (r), which is the IRR. Because of the nature of the formula, however, IRR cannot be
calculated analytically and must instead be calculated either through trial-and-error or using
software programmed to calculate IRR.

Generally speaking, the higher a project's internal rate of return, the more desirable it is to
undertake. IRR is uniform for investments of varying types and, as such, IRR can be used to rank
multiple prospective projects on a relatively even basis. Assuming the costs of investment are
equal among the various projects, the project with the highest IRR would probably be considered
the best and be undertaken first.

IRR is sometimes referred to as "economic rate of return" or "discounted cash flow rate of
return." The use of "internal" refers to the omission of external factors, such as the cost of
capital or inflation, from the calculation.

 Advantages and disadvantages of IRR

 TIME VALUE OF MONEY

The first and the most important thing is that the internal rate of return considers the time value
of money when evaluating a project. This is a huge downfall in accounting rate of return, an
average rate of return and Pay Back period. One can measure IRR by calculating the interest rate
at which the PV of future cash flows is equal to the capital investment required.

 SIMPLICITY
The most attractive thing about this method is that it is very simple to interpret after the IRR is
calculated. If the IRR exceeds the cost of capital, then accept the project, but not otherwise. This
is very easy to visualize for managers, which is why it’s preferable unless they come across
occasional outstanding situations, like mutually exclusive projects etc.

 HURDLE RATE / REQUIRED RATE OF RETURN IS NOT

REQUIRED
The hurdle rate is a difficult and subjective thing to decide. In IRR, there is no requirement for
finding out the IRR hurdle rate or the required rate of return. It is not dependent on the hurdle
rate, so the risk of a wrong determination of the hurdle rate is diminished. If one calculates
the net present value, profitability index etc., that will require the hurdle rate.

 Advantages

ECONOMIES OF SCALE IGNORED

One pitfall in the use of the IRR method is that it ignores the actual dollar value of benefits. One
should always prefer a project value of $1,000,000 with an 18% rate of return over a project
value of $10,000 with a 50% rate of return. There is no need for in-depth analysis; we can clearly
see that the dollar benefit of the former project is $180,000, whereas the latter project’s dollar
benefit is only $5,000. There is no comparison as to which is more worthwhile. The IRR method
will rank the latter project—with a much lower dollar benefit—first, simply because the IRR of
50% is higher than 18%.

IMPRACTICAL IMPLICIT ASSUMPTION OF REINVESTMENT RATE

While analyzing a project with the IRR method, it implicitly assumes the reinvestment of the
positive future cash flows at IRR for the remaining time period of the project. If a project has a
low IRR, it will assume reinvestment at a low rate of return; on the contrary, if the other project
has a very high IRR, it will assume a reinvestment rate at the very high rate of return. This
situation is not practically valid. When you receive those cash flows, having the same level of
investment opportunity is rarely possible. In addition to that, making the assumption that at one
point in time, one company will have more than one reinvestment rate, is simply not possible. If
a company has more than one reinvestment rate opportunity, then it will invest at a higher rate.
DEPENDENT OR CONTINGENT PROJECTS
Many times, finance managers come across a situation when the project under evaluation creates
a compulsion of investing in other projects. For example, if you invest in a big transporting
vehicle, you will also need to arrange a place for parking it. Such projects are called dependent
or contingent projects, and must be considered by the manager. IRR may permit the buying of
the vehicle, but if the total proposed benefits are wiped off by having to arrange the parking
space, there’s no point in investing.

MUTUALLY EXCLUSIVE PROJECTS

Sometimes investors come across mutually exclusive projects, which means that if one is
acceptable, then the other is not. Building a hotel or a commercial complex on a particular plot of
land is an example of a mutually exclusive project. In such situations, knowing whether they are
worth investing in is not enough. The challenge is to know which investment is the best. The
IRR method will give a percentage interpretation value, but that is not enough. This is connected
to the first disadvantage of economies of scale, which the IRR ignores.

DIFFERENT TERMS OF PROJECTS

Consider two projects with different project durations. One ends after 2 years and the other ends
after 5 years. The first project has an additional point of reinvesting the money, which is
unlocked at the end of the 2nd year for another 3 years until the other project ends. This point is
not considered by the IRR method.
CALCULATION OF IRR IS NOT POSSIBLE
If later cash inflows are not sufficient to cover the initial investment, in that case, IRR cannot be
found. IRR is then a discounted rate at which the Present Value of Cash Inflow equals the
Investment or Present value cash outflow.

THE OBJECTIVE OF WEALTH MAXIMIZATION

Importantly, when there is a conflict in the ranking of mutually exclusive projects between net
present value (npv) and IRR, at that time, NPV criteria supersedes IRR criteria because NPV
criteria exactly measure the amount by which the value of the firm will increase. The objective
of Financial Management in terms of wealth maximization is met, to which extent it can be
measured by NPV. IRR will only be able to decide whether a project is worth accepting or not,
but what increase in wealth will occur cannot be measured by IRR.
Name: Saghir Abbas

Class: BBA(Hons)

Roll no: BBHM-F15-024

Subject: corporate finance

Submitted to: Sir bilal cheema

SUPERIOR UNIVERSITY LAHORE