International Conference on Chemical, Material and Food Engineering (CMFE-2015)

Using the Net Present Value Rule to Make

Value-Creating Investment Decisions

Xu Hui
School of Business management
Tong Hua Normal University
Tong Hua, China
[email protected]

Abstract—At present, most of the researches on net present skills in identifying potentially successful projects and
value are focused on single objective cases. This paper carrying them to fruition (we use the terms project,
discusses net present value problem with upper level multi- investment, and performance proposal interchangeably). If
objective optimization. In order to solve the problem the capital investment program fails, suppliers of funds-the
efficiently, we present a genetic algorithm using shareholders and creditors-could lose confidence in the
interpolation. According to the NPV rule, if the investment ability of the firm's managers to make good investment
has a positive (negative) NPV it creates (destroys) value and decision and may became reluctant to provide additional
should be undertaken (rejected) .The NPV rule is a good funds in the future.
investment decision rule because it adjusts the investment's
What is a good investment decision? From a financial
expected cash flows for both their timing and risk and has
the convenient property of being additive. Most important is
management perspective, a good investment decision is a
the capacity of the NPV method to evaluate the value- decision that raises the current market value of the firm's
creating potential of an investment proposal. In addition, the equity, thereby creating value for the firm's owners. An
NPV of an investment proposal is an estimate of the current investment decision can have other objectives, but
value the proposal will create or destroy if undertaken. managers who ignore the value-creation objective may
jeopardize both the future of there firms and their
Keywords-net present value; investment decisions; capital employment prospects. The value-creating investment
investment process; capital budgeting; objective optimization decision must raise market value, not book value or
accounting profit. Shareholders cash in on their investment
I. INTRODUCTION by selling their shares for cash, not for accounting profits.
The steps involved in applying the NPV [1-3] rule to Capital budgeting involves comparing the amount of
evaluate an investment proposal are summarized in this cash spent today on an investment with the cash flows are
paper. Tow inputs are required to calculate a project's NPV: spread over time, they cannot be compared directly with
(1) the expected cash-flow stream that the project will cash spent today. Recall that a dollar received later is
generate over its useful life and (2) the appropriate cost of worth less than a dollar received earlier cash inflows. This
capital that reflects the risk of the expected cash-flows. preference for “early cash” is called the time value of
The cost of capital is the rate at which the project's future money.
cash flows need to be discounted to compare their present Discounting is the mechanism used to convert future
value with the investment cost. This paper shows how to cash flows into their equivalent value today. In other
estimate a project's expected cash-flow stream, and this words, discounting adjusts future cash flows for the time
paper shows how to estimate its appropriate risk-adjusted value of money. For example, a riskless cash inflow of
cost of capital. $1,100 available one year form now is worth $1,000 today,
if the firm can earn 10 percent on cash deposited now in a
II. DISCUSSED PROBLEMS risk-free saving account.(If a firm deposits $1,000 today in
a bank that offer 10 percent, it will have $1,100 in one
Wherever Times is specified, Times Roman or Times
year.)The $1,000 is the present value, or discounted value,
New Roman may be used. If neither is available on your
of the $1,100 of future cash inflow at a discount rate of 10
word processor, please use the font closest in appearance
percent. This paper shows how to calculate the discounted
to Times. Avoid using bit-mapped fonts if possible. True-
value of a cash flow occurring at any date in the future.
Type 1 or Open Type fonts are preferred. Please embed
Apart from the timing issue, the risk associated with
symbol fonts, as well, for math, etc.
future cash flows is also an issue. Future cash flows are
One of the most important decisions a manager can
called discounted cash flow (DCF) models. This paper
make is the capital investment decision. This key decision
presents the net present value (NPV) model and briefly
requires spending cash now to acquire long-lived assets
examines a useful variation, the profitability index
that will be a source of cash flows in the future. A
(PI) .This paper presents and compares other DCF and
successful capital investment program [4-5] will contribute
non-DCF model and concludes that the NPV approach to
positively to the firm's financial performance for many
investment appraisal is superior to alternative methods.
years. The firm's managers will be commended for their

© 2015. The authors - Published by Atlantis Press 644

 There are two critical elements in a DCF valuation. •How to calculate the present value of a stream of
One is the identification and measurement of the project's future cash flows
expected cash flows and the other is the estimation of the • The NPV rule and how to apply it to investment
appropriate discount rate required to calculate the project's decisions
present value. This paper is devoted entirely to the first •Why a project's NPV is a measure of the value it
issue and this paper deals with the second. In this paper, creates
we assume that both the investment's expected cash-flow
•How to use the NPV rule to choose among projects of
stream and its appropriate discount rate are known and
different sizes or different useful lives
show how to calculate the investment's NPV. We also
explain what NPV measures and how it should be III. THE CAPITAL INVESTMENT PROCESS
interpreted.
The valuation of a project is a critical element in the The capital investment decision, also called the capital
capital investment process, but it is not the only one. Thus, budgeting decision or capital expenditure decision,
we review the major steps involved in a capital investment involves steps that are summarized in Figure 1.The process
decision before we explain how to perform an NPV is initiate when the firm identifies business opportunities
analysis. After reading this paper, you should understand that can be translated into potentially valuable investment
the following: proposals. This is arguably the most important step in the
• The major steps involved in a capital budgeting generation of ideas and the uncovering of opportunities
that could lead to successful long-term investments.
decision

Type of investment Input Decision rule Performance evaluation

•Required •Expected cash-flow •Net present value •Monitor the magnitude and
investment stream •Profitability index timing of cash flows
•Replacement •Discount rate •Internal rate of •Check it the project still
investment return meets the selection criterion
•Expansion •Payback period •Decide on continuation or
investment abandonment
•Diversification •Review previous steps if
investment failure rate is high

Figure 1. The Capital Investment Process

Identified investment proposals must then be require the firm to estimate the addition sales revenues,
evaluated financially. The inputs required for the financial margins, and working capital that the expansion is
evaluation of a project include. (1) the estimation of its expected to generate. Finally, financial evaluation for
useful life; (2) the estimation of the cash flows the project diversification investments is usually the most difficult.
is expected to generate over that useful life; and (3) the The cash flows these proposals are expected to generate
appropriate discount rate require to calculate the present are probably the hardest to forecast because the firm will
value of the project's expected cash-flow stream. enter an industry it does not know as well as its own.
Estimating the parameters required for the financial After the proposal's financial parameters have been
analysis of a proposed investment is not an easy task; these estimated, an investment criterion should be applied to
estimation procedures are explained in detail in this paper decide whether the proposal will be accepted or rejected.
(cash flows) and appropriate discount rate. This paper examines the net present value (NPV) rule in
Proposals are usually classified by how difficult it is detail and the profitability index briefly. This paper looks
to estimate the key parameters needed for financial at other popular selection criteria, such at the internal rate
evaluation. Required investments are those the firm must of return and the payback period, and discusses the
make to comply with safety, health, and environmental profitability index in more detail.
regulations. In this case, managers want to know whether
the present value of the cash expenses needed to comply IV. APPLYING THE NET PRESENT VALUE TO A
with the regulations is greater than the cost of closing CAPITAL INVESTMENT DECISION
down. If it is, the project should be abandoned. Estimating Applying the NPV rule to a capital expenditure
such expenses should not be too complicated because, in decision is a straightforward exercise assuming that the
most case, they are already specified by the regulatory entire project is expected to generate over its anticipated
authorities. Replacement investments are essentially cost- useful life and the cost of capital applicable to the
saving projects that do not generate extra cash inflows. investment under consideration. After these inputs are
Their future cash benefits (basically cash savings) consist estimated, the present value of the project's stream of
of reduction in anticipated costs that managers can identify expected cash flows is calculate by discounting the cash
with relative ease. Financial evaluation for expansion flows at the project's cost of capital. Then, the project's
investments is more challenging because these projects

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initial cash outlay is subtracted from this present value to It adjusts for the risk of the project's expected cash-
find the project's NPV is negative, the project is rejecting. flows
We use an example to explain the procedure. It is additive
Sunlight Manufacturing Company (SMC) has been The first three properties are essential for any selection
successfully producing and selling various types of criterion used to decide whether to accept or reject a
electrical equipment for the last twenty years and is capital investment. In this paper, the comparisons of the
considering adding a new product, a designer desk lamp, to NPV rule to alternative selection criteria are based on these
its existing product line. The firm would have to spend important properties.
$2,360,000 now to launch the new product, which is Although a project with a positive NPV is expected to
expected to be obsolete after five years. The investment is create value, NPV does not provide any indication about
expected to generate an annual net cash flow of $832,000 the source of value creation. Firms can generate positive
at the end of its first year, $822,000 at the end of its second NPV projects and create value for the firm’s owners for
year, $692,000 at the end of its third year, $554,000 at the many reasons. The firm may have creative managers
end of its fourth year, and a terminal net cash flow of supported by a superior workforce. It may hold a strong
$466,000 at the end of its fifth year. The terminal cash position in a product or service market that makes it
flow includes the estimated resale value of any equipment difficult for new entrants to compete on an equal footing.
used to manufacture the product; net of any liquidation More important, some projects cannot be easily replicated
cost. The project's estimated cost of capital is 7.6 percent. by competitors, either because they require expertise that is
Should SMC launch the new product? To answer this specific to the firm or because they are protected by
question, we need to find the project's NPV. patents. For these reasons, a firm may be able to generate
First, the present value of each expected cash flow is cash flows from some of its investments that have present
calculated by multiplying it by its corresponding discount values higher than the cost of investing in these projects.
factor at the cost of capital of 7.6 percent (see Figure 1 Part
I). Then, the initial cash outlay of $2,360,000 is subtracted VI. LIMITATIONS OF THE PRESENT VALUE
from the total present value of the project's expected cash- CRITERION
flow stream to obtain the project's NPV: Although the NPV criterion [8] can be adjusted to deal
NPV (New project at 7.6%) =- with particular cases, such as the comparison of two
$2,360,000+$2,775,083=$415,083 projects of unequal size or unequal life spans, in other
The project's NPV is positive, so SMC should launch cases, the required adjustments to the NPV criterion are far
the designer desk lamp. too complex to be easily implemented. In most cases, these
As you may have already noticed, the computation of situations arise because the NPV criterion is a take-it-or-
NPVs for multiple-period project can be tedious. leave-it rule that is based only on the information available
Fortunately, computer-based spreadsheets can make the [9-10] at the time the NPV is estimated. Hence, the NPV
task of computing NPVs quite easy. We show in Part II of criterion ignores the opportunities to make changes to the
TM
Figure 1 how Microsoft Excel can be used to compute project as time passes and more information becomes
the NPV of the designer desk lamp project. Commands are available. NPV is estimated from the stream of expected
similar for other types of spreadsheet programs. Note also cash flows generated by the proposal and discounted at the
that most electronic financial calculators have several project’s cost of capital, which depends on the project’s
financial functions, including an NPV function. To use this risk. The estimation of both the cash flows and their
function, simply enter the cash-flow values starting with corresponding cost of capital depend on information
the initial cash outlay and ending with last period cash available at the time NPV is calculated. This information
flow. Then, enter the investment's cost of capital and press involves factors such as the marketability of the product,
the NPV key. The calculator will compute the present its selling price, the risk of obsolescence, the technology
value of the expected cash-flow stream and provide the used in manufacturing the product, and the economic,
project's NPV. You can also calculate NPV using the regulatory, and tax environments. A project that can be
present value of $1 paid or received at the end of any adjusted easily and inexpensively to significant changes in
period up to twenty periods and at discount rates ranging these factors will contribute more to the value of the firm
from 1 to 20 percent. A far more complex and challenging than indicated by its NPV. It will also be more valuable
task is the estimation of the inputs required to perform this than an alternative proposal with the same NPV that
calculation, namely, the project's expected cash-flow cannot be altered as easily and as cheaply. A project’s
stream and its corresponding cost of capital. flexibility, that is, the ability of a project to adjust to
changing circumstances, is usually described by
V. WHY THE NPV RULE IS A GOOD managerial options, which can be exercised to alter a
INVESTMENT RULE project during its useful life.
The option to switch technologies and the option to
The NPV rule is a desirable investment decision [6-7]
abandon a project are embedded in most investment
rule because, as discussed in this section, it has the
projects. However, these are not the only managerial
following properties:
options. Managers have many opportunities to enhance the
It is a measure of value creation: when the project's
value of an investment during its lifetime as circumstances
NPV is positive, the project creates value, and when it is
change. A counterpoint to the option to abandon a project
negative, the project destroys value
is the option to expand the project. For example, suppose
It adjusts for the timing of the project's expected cash
the designer desk lamp is a big winner and the project
flows
needs to be expanded to meet increased demand.

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Regardless of the machine used to manufacture the lamps, comparison should be made between sequences of projects
SMC’s management will have the option to expand the of the same duration. The calculations for this comparison
production line. But, contrary to the previous cases, it is are easier if the projects' annuity-equivalent cash-flows are
not clear that the value of this option will be different for compared. The project with the lowest annuity-equivalent
different machines because there is no reason to believe cost or the highest annuity-equivalent benefit should be
that it will be easier to increase the production of lamps selected.
with one machine rather than with the other one. However, Most projects have managerial options, options to
this is not always the case, and a project that can be change course after the project is launched, which are
expanded is worth more than a project that cannot. An ignored in standard NPV analysis. The added value
investment can usually be postponed, so another important provided by these options is difficult to estimate. Although
managerial option is the option to defer an investment. sensitivity analysis is not a perfect substitute, it can
This kind of option is particularly valuable in the mining identify the most critical options embedded in a project,
and oil extraction industries where the output (mineral or this providing valuable information for the final decision to
oil) prices are particularly volatile. For example, the NPV accept or reject.
of an oil reserve may be negative, given the current market
expectations about the future price of oil. However, ACKNOWLEDGMENT
because the development of the reserve can be postponed, This work was supported by the Project of Education
sometimes for many years, the capital expenditures needed Department of Jilin Province (Grant No.2014388) and by
to start the extraction of oil can be deferred until the the Doctor Support Project of Tong Hua Normal
market prices rise. And the more volatile the oil prices, the University under Grant No.201412.
higher the chance that the NPV of the reserve will become
positive, and the higher the value of the option to defer the REFERENCES
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