Investing Feeds

Net Present Value (NPV) Part Two

Before the worked examples, it is important that you read the first part of NPV, as the underlying concepts, and their limitations, are very important. To utilize NPV as a tool for ranking Investments it is important to arrive at a rate at which to discount the estimated future cash flows. In terms of Share purchases, future cash flows are either dividends paid, or increase in share value. The following is a highly simplified example, and care should be taken when arriving at estimates of growth and dividend payments, as well as the rate at which those estimates are discounted.

A Plc Provides the following Data

Dividend Paid for next five years of $0.50

Growth in Share Price Per Annum of $0.10

Independent Analysts have confirmed that this is a low risk investment and the investor is happy to apply a 10% discount rate which reflects Inflation and what could nominally be expected on a similarly low risk investment

B Plc Provides the following Data

Dividend Paid for next five years of $0.50

Growth in Share Price Per Annum of $0.20

Independent Analysts have confirmed that this is a high risk investment and the investor is happy to apply a 20% discount rate which reflects Inflation and what could nominally be expected on a similarly low risk investment.

Both shares are quoted at $1.50

Therefore total cash flows for a five year investment are as follows

A Plc

Five dividends of $0.50 = $2.50

Five years of growth in Value of $0.10 = $0.50

Net cash flows at year five are therefore $3.00

B Plc

Five dividends of $0.50 = $2.50

Five years of growth in Value of $0.20 = $1.00

Net cash flows at year five are therefore $3.50

Without the application of the two discount rates B Plc promises to create more wealth for the investor, however the application of the rates (which can be found on www.accaglobal.com/archive/sa_oldarticles/28448 along with another worked example) provides the following NPV for each investment

A Plc

Net cash flow $3.00

NPV Multiplier 0.621

NPV = $1.863

B Plc

Net cash flows $3.50

NPV Multiplier 0.402

NPV = $1.407

Therefore, in a matter of simple ranking between investments it is easy to see that A Plc provides a better return in reality, but what is also important to note is that if B Plc were the only choice of investment, that it is a wealth destroying one and should not be made under any circumstances as the original investment ($1.50 ) is higher than the Net Present Value of the return.

Used with caution the NPV is a powerful tool for appraising investment, but be aware of its limitations.