NPV = PV - required investment = 373,832 – 350,000= £23,832
In other words, the building is worth more than it costs- it makes a net contribution to value. The formula for calculating NPV can be written as:
NPV = Co + C1
1+r
However, it is important to remember that Co, the cash flow at time period 0 (that is, today) will usually be a negative number. In other words, Co is an investment and therefore a cash outflow. In the example above, Co = -£350,000. Increasing NPV is a sensible objective for a company and as long as an investment has a positive net present value an investment in theory should be accepted.
One commonly used approach other than the NPV rule is the Payback Rule measures the length of time it takes to recover the initial investment. Put another way the payback period is the amount of time required for an investment to generate cash flows sufficient to recover its initial cost. Based on the payback rule, an investment is acceptable if its calculated payback period is less than some pre-specified number of years. The payback period rule has some major disadvantages compared to the NPV rule. Firstly, the payback period is calculated by simply adding up the future cash flows. There is no discounting involved as with the NPV rule, so the time value of money is completely ignored. The payback rule also fails to consider any risk differences between various investment opportunities, it would be calculated the same for very risky and very safe projects. However, the biggest problem associated with the payback rule is the fact of coming up with the right cut-off point. When a cut-off point is arbitrarily chosen say for example two years, cash flows after the second year are ignored entirely even though the cash flows could increase rapidly after the second year. By ignoring time value as the payback rule does, we may be lead to take investments that are actually worth less than they cost. After all, £100 received today is worth more than £100 received in a year’s time because of the time value of money. Also by ignoring cash flows beyond some subjective cut off point, we may be led to reject profitable long term investments Generally, using the payback rule will tend to bias us towards shorter-term investments and may ultimately lead to a short termist attitude from decision makers.
However, the payback rule does have its advantages over the NPV rule. The main reason for this is the fact that many decisions don’t warrant detailed analysis because the cost of the analysis would exceed the possible loss from a mistake. Usually if an investment pays back rapidly and has benefits extending beyond the cut off period then it is likely the investment will have a positive NPV. In addition to its simplicity, the payback rule has two other advantages. As it is biased towards short term projects, it is therefore biased towards liquidity. Therefore such projects are less likely to be risky and will ensure the business has enough liquid assets to survive. Also the cash flows that are expected to occur later in a projects life are probably more uncertain. To summarise the payback rule does have its criticisms but because it is so simple it can easily be used as a screen for dealing with minor investments.
Another attractive, but flawed approach to making capital budgeting decisions involves the Average Accounting Return (AAR). There are many different definitions of the ARR but generally it can be defined as an investment’s average net income divided by its average book value. Based on this rule a project is acceptable if its average accounting return exceeds a target average accounting return. For example if an investments ARR is calculated to be 20% and the firm has a target ARR less than 20%, then this investment would be acceptable, otherwise it is not. One major drawback of the ARR rule compared to that of the NPV is that the ARR is not a rate of return in any meaningful economic sense. It is simply a ratio of two accounting numbers, and it cannot be compared to the returns offered on the financial markets or in a savings account for example. Like the payback rule the ARR ignores time value. When figures are averaged that occur at different times, the near future and distant future are treated in the same way. There is no discounting involved as there is using the NPV rule. A second problem with the ARR rule is again similar to the problem with the payback period rule concerning the lack of objective not subjective cut off period. Because the calculated ARR figure cannot be compared to a market return as I have already explained, the target ARR must somehow be specified. There is no generally agreed-upon way to do this. One way of doing it is to calculate the ARR for the firm as a whole and use this as a benchmark, but there lots of other ways. However, the biggest pitfall of the ARR rule compared to that of the NPV rule is the fact that it doesn’t look at the right things. Instead of cash flow and market value, it uses net income and book value. These are both inferior and poor substitutes. As a result, an ARR doesn’t tell us what the effect on share price will be of taking an investment, so it doesn’t tell us what we really want to know.
The only really advantage of the ARR compared to the NPV rule is that it can nearly always be computed. The reason is that accounting information will almost always be available, both for the project under consideration and for the firm as a whole. However, even though once the accounting information has been made available it can always be converted to cash flows, so this is not a particularly convincing advantage. It is however easy to calculate but the advantages of the rule are far outweighed by the disadvantages and the ARR rule in the main is far inferior to the NPV rule.
In conclusion, the net present value of an investment is one of the most important concepts in finance. It is important to keep in mind that the NPV is always just the difference between the market value of an asset or project and its cost and the financial manager acts in the shareholders’ best interests by identifying and taking positive NPV projects. Finally NPVs can’t normally be observed in the market and hence they must be estimated. Because there is the possibility of a poor estimate financial managers will use other approaches for examining projects to provide additional information about whether or not a project truly has a positive NPV. The payback and ARR are just two of these rules each with there own advantages and disadvantages.
References
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Richard A. Brealey/Stewart C. Myers, Principles of Corporate Finance (McGraw Hill International Editions)- Chapter 2
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Ross. Westerfield. Jordon, Fundamentals of Corporate Finance (McGraw Hill International Editions)- Chapter 9