Investing Feeds

If you invest in a firm, you want to hope they utilize NPV as a tool for vetting potential projects, as this method is the only mathematically correct measure of the Economic Value Added (EVA) to a company (which should then equate to Market Value Added (MVA), or an increase in share price.) NPV is a method of discounting future revenue to arrive at a dollar figure which is the present value of that revenue today (or as Economists say, at time period 1.) The reason for doing this is simply that money now, is worth more than money in the future, for a number of reasons. Ignoring Inflation (although that is a factor) an investor is able to access the capital market at a certain rate (r), and either borrow to finance need, or to place surplus money on deposit and earn interest. If an investor is to buy stock they must be assured that the return (P) is greater than the rate (r) at which they could place money on deposit (as this kind of investment is relatively risk free.) Further it is theoretically sound to assume that as risk increases, so does the rate (r) by which future revenues should be discounted. Therefore as an investor, once cash flows have been calculated and NPV arrived at the simple rule of Investment Appraisal is this, consummate with a given level of risk, discount cash flows at r and arrive at a figure for return P, this is the NPV of the investment then, simply,

If NPV positive, accept the Investment as wealth has been created

If NPV negative, decline the investment as wealth has been destroyed

This technique is used by Internal Finance Analysts and by External Analysts to assess the success of any given investment. It sounds complex, but as will been seen in the next part of this guide, it can also be used by individual investors to asses share purchases with some level of certainty, and can quickly tell if an investment provides a better rate of return than another. NPV is a powerful tool but has serious limitations. Analysts utilise the CapM rate, a complex statistical tool to arrive at the rate at which future cash flows are to be discounted, it is not possible, generally to arrive at such an accurate figure, and calculating the CapM is at PhD Level Mathematics, therefore, without such an accurate rate, results can be in error (indeed the CapM is not perfect, and Analysts utilize probability theory to smooth out the margins of error.) NPV is, however, a powerful tool and even with an assumed rate, or desired rate of return, can quickly and easily rank investments in terms of Wealth Created.