The Strengths and Weaknesses of the Net Present Value Approach - Coursework Example

The Theoretical Rationale for the Net Present Value Approach to Investment Appraisal Introduction Investments relay to one of the most significant long term choices of a business enterprise. It is the creation of assets with the main aim of accumulating revenue or benefits in the future period. Fundamentally, the process of investment entails making use of the financial resources to buy fixed assets which will eventually yield benefits to the company over a time period. Investment appraisal is a method of evaluating the investment program whether it would profitable to the company or not. The methods used include; the payback period, Average Rate of Return, Net Present Value among others (Lumby & Jones, 2003; p. 180). This process is significant based on various reasons; it is a way of evaluating the productivity of an investment project, it also assists in improving on the productivity and effectiveness of the company. The process is vital in guiding the benefits of the time value of money and gives room for comparison of a venture by offering valuation of the cash payments on the investment project and the cash receipt anticipated to be recognized. This essay focuses on the theoretical analysis of the net present value in comparison with other methods of investment appraisal. The Rationale behind the NPV Approach The Net Present Value (NPV) is a tool for determining the profitability of a pending project or investment in the process of investment appraisal. It is therefore the difference amid the total benefits of the project and the total costs incurred by the project over time. In case a business project incurs cash receipts, it is probable to save it in a bank. Therefore, what is sacrificed by a business by having to be patient for the inflow of cash is the lost interest on the total sum that would have otherwise been saved. In a different picture, it is probably that the business will have obtained debt financing to venture into a particular project of its choice that it deems to be profitable. Hence, the opportunity cost of the company of having to be patient for the inflows from the venture is the paid interest on the money borrowed as capital. In addition, when making use of the Net Present Value process of decision making, a company must venture in a project that carries a positive NPV and shun away from that project with negative NPV (Lipsey & Chrystal, 2011; p. 253). Here is a scenario where there are changes to the NPV when the capital cost is either increased or decreased. It must be noted that the cost of capital is indirectly proportional to the Net Present Value. This implies that in case the cost of capital of the organization is increased then it translates to the risk being increased that eventually results into a reduction of the NPV. For instance; if the cost capital is put at 12% on an investment of $ 342,000 and eventually the cost of capital is hiked to 20% eventually the NPV at 20% cost of capital is equal to $ 96,400. This is an indication that the NPV has gone down. In case the Cost of Capital of the company goes down then it implies that projects’ risk also goes down which leads into a rise in the quantity of the NPV. Comparing the Internal rate of return (IRR) of every project and the NPV and whether the project must be accepted or not, it is easier to establish the probability of investing or not investing in the project. In the event that the IRR cost way above the cost of capital, the company will receive more returns than it would have ventured into the project. On the contrary, when the IRR is below the cost of capital it implies that there are no benefits that would be realized from the project, thus the project must be abandoned. The Internal Rate of Return has of late been one of the most important economic criteria for assessing the capital of investment projects given that the fact managers can attest with the rates of return. IRR is determined by establishing the rate of discount in which the total present value of all the inflows of cash equals the Net investment figure; that is to say the net present value is zero. It is simple to solve for IRR in case there are equal cash inflows for consecutive year. IRR makes assumption that re-venturing of the cash flows in the investments has similar rates of return. Thus, IRR seems to exaggerate the yearly equivalent return rates for an investment whose interim cash flows re-ventured at a lower rate that the derived IRR. This projects a challenge particularly for projects with high internal rate of return, since there is often not any other project of investment in the interim that can realize a similar rate of return as the initial project. IRR is autonomous of the cost of capital and can be derived by trial and error based method even if the company has not made a decision on the percentage of cost of capital. The Superiority of the NPV Method over the Rest of the Investment Appraisal Methods In capital budgeting, the various methods used in the evaluation an investment have their own unique disadvantages and advantages. Notably by taking all factors constant use of the net present value and the internal rate of return determinants in evaluation of investment projects normally leads to equal or same conclusion. Nevertheless, there are other projects for which use of IRR might not be as effective as applying the net present value in discounting the cash flows. The main challenge of using IRR happens to be its main strength in that it makes use of a single rate of discount to assess every form of investment. Even though use of one rate of discount might simplify the problem, there are other scenarios that can cause challenges for the internal rate of return. In case an analyst is assessing two unique investment projects, both of which have the same or similar discount rate, similar risks, projectable cash flows and shorter life time, IRR might possibly work. The interesting factor is that the rate of discount normally varies considerably as time goes by. For instance, using the rate of return on a Treasury bill otherwise known as T-bill that has been in existence for last 20 years as a rate of discount, one year T-bill with a discount rate ranging from 1% and 12% for the 20 year period apparently shows that the discount rate is varying gradually (Baum & Hartzell, 2012; p. 130) IRR and NPV are both methods for discounting cash flows and they are actually important in the process of making decisions in any process of investment appraisal even though there are other fundamental rationalities that may prompt portfolio managers in selecting NPV as opposed to the IRR. Some of these reasons include; reinvestment assumption which means that there is a presumption in NPV that the flow of cash realized in the project is re-ventured at the rate of discount that is commonly known as cost of capital. In the IRR the return are earned using the return at the IRR on cash flows. Besides, the NPV method reveals the final outcome in dollars or pound as opposed to the percentage and thus it gives room for the firm to determine the benefits accrued from the investment on the invested project in unqualified terms. Last but not least non-conservative cash flows where the rate of discount is projected to be unique over the project’s life, such as deviations can effectively be handled in the NPV as opposed to IRR. Net Present value is also rampantly applied valuation tool which has served many businesses for over a century even though it may fail to meet the new needs in the current time. Despite the apparent strengths, this method of valuation has two main challenges when it is applied to the risk based valuation. First and foremost by attaching the risk premium to the rate of discount, an assumption is made in regard to the risk charges which are proportional to the asset value. Second, the NPV is then calculated from the anticipated cash flows, there is a tendency to ignore the effect of the diversifiable risk on the valuation of the asset. These challenges are decisive for modern valuation scenarios. On the first instance, financial markets have made attempts to distinguish risk bearing and cash provision; this by considering an easy swap that a zero value but huge risk. On the second account, the investors who are able to afford to ignore risks that are diversifiable capitalize infinitely for well hedged investors. In most markets, these type of investors do not seem to exist that correspond for the assets taking place among the buyers of the constrained capitalization and the capacity for risk bearing which is commensurate to the size of the asset. These investors are stipulated to put into consideration their evaluation of the asset value. There are authors who believe that there is necessity for risk based assessment and ponders over why most investors focus wrongly on the mutual efforts in perfect markets evaluation. Developing this argument further, it can be noted that such scenarios such as the one addressed above has never been adequately dealt with. This is due to fact that in the past more contracts or project were entirely capitalized as opposed to the way they are currently. For instance, it looks rational to be of the thought that risk premium on a natural oil field is based on the risk posed in the price fluctuations of the gas and closely relative to the investment in the field. However this does not adequately reconcile with a fiscal swap contract that purchases gas but demands no initial investment. In this case, in case the risk premiums were relative to the value of the swap. The risk premium would eventually be zero, although the prices of the swap are analogous to the price risk in the field. Specifically, this challenge has created difficulties for most energy firms to put to comparison the gas deals with the gas swap deals on a similar risk ground (Campbell & Brown, 2003; p. 344). In the current capital markets, there is no often group cash venture with risk taking. As a matter of fact, one could argue in the perspective that at any given point in time an investment project with proper guarantees could anticipate to have all its needs of cash being fulfilled by any quantity of suppliers who are more ready to assume a minimal spread to risk-free rates of interest. On the contrary, cash mostly of a commodity currently compared to the way it was in the past. This impels the valuation duty by comprehending the cost of risk as opposed to the cost of cash. The second constraint of using NPV is the inability to account for the particular risk. Under the presumption of Modigliani-Miller commonly known as the MM framework advanced in 1958, the companies are not supposed to price the personal or particular risk given the shareholders are in a position to hedge it away costless. One of the fundamental presumptions that lie behind the MM theory is that there is availability of capital in unlimited amount to any company at a price that is just for all. Empirically, the companies find their capital constrained in the short term at any considerable price which forces the company to take responsibility of risk in their decisions. A worst result on an investment project could for instance cause a company to hold up on the decision to pay higher costs or create value for the projects on the new outsourced financing compared to what would have otherwise had. Risk must thus be allocated a cost to trigger managers to prevent assuming risks which are not compensated (Khan & Jain, 2007; p. 27). The literature on finance in the recent decade has identified the limitations of capital that companies experience and revealed in most scenarios that management of risk is affirmed at the level of the firm due to lack of applicability of the M-M presumptions. There is one vital illustration that shows how risk can affect the process of capital budgeting choices and damage the value of shareholder. The main objective of this discussion has been to show how to make use of the different valuation methods as opposed to supporting the pricing of the risks that are diversifiable found on the availability of limited capital. In general the models of valuation can be established, even though this is a simple illustration that is used to reveal the mutual approach and distinction of the methodology with Present value of the adjusted risk (PVAR), Cash flow Adjusted risk (CFAR) and NPV. The latest approach to valuation is the Risk adjusted present value (David, 2001; p. 57). The Bad, the Ugly and the Good of the NPV A firm is contemplating a main investment which involves a $ 100 million venture on a major power source upfront. The top management is entailed to make major decisions in this case given the magnitude of the project. A year after the investment the firm is in a position to liquidate its equity in the project for $ 110 million. The good part of the decision is to reject the venture when it is must be rejected. In this case venturing into the project is overruled by the chances accessible in the manager’s finance and capital markets training. Thus investing the same $ 100 million at 10.3% in a discount bond for one year it yields $ 110.3 million. In this scenario the project is predominated by a capital market choice thus no other considerations would confirm selecting the project that is already dominated. The bad choice is to refute a venture when it must be must accepted. A project must be taken when it has positive NPV but when a project is merely a onetime venture, it entails the privileges to the venture. It is notable that just because the present rates of interest cannot confirm a project does not imply that this will not be the case at all times. The rights to the venture comprise of options for rate of interest that is inherent to the project of investment. Given the fact there is nothing that will impel the investor to take a project that has a negative NPV hence the investor has an obligation to take on projects with positive NPV. The ugly scenario is accepting a venture when it must be refuted. The critical mistake of making use of the NPV rule is to select or accept the project. That is to say venturing into the project merely due the positivity of the NPV might be risky especially when a project has an interest rate of 9.999%, there is dilemma as to whether the project can give $ 1000 in profit by investing 10%. The main advice under this rule is to take on a project if the investor is satisfied that it does not interfere with the capability of taking on another rivalry project (Stephen, 1995; p. 96). References Baum, A. E and Hartzell, D. (2012). Global property investment: strategies, structures, decisions. Chichester, West Sussex, Wiley-Blackwell. Campbell, H. F., & Brown, R. P. C. (2003). Benefit-cost analysis: financial and economic appraisal using spreadsheets. Cambridge: Cambridge Univ. Press. David C. S., (2001), NPV No More: RPV for Risk-Based Valuation, Risk Capital Management Partners, New York, NY 10153, Harvard Business School Lumby, S., & Jones, C. (2003). Corporate finance: theory & practice. London, Thomson. Lipsey, R. G., & Chrystal, K. A. (2011). Economics. Oxford, Oxford University Press. Khan, M. Y., & Jain, P. K. (2007). Financial management. New Delhi, Tata McGraw-Hill. Ross, S. A, (1995), Uses, abuses, and alternatives to the net-present-value rule, Financial Management; Autumn 1995; 24, 3; ABI/INFORM Global. Read More