How does the NPV model relate to value creation at a company?
Even when there is agreement on the goal of measuring value creation, crafting and implementing good
performance measures is no easy task. Such measures must deal with the fundamentals that drive
market values, including expectations of future performance, risks associated with those expectations
and rates of return otherwise available to investors. Some recommend measuring performance by
looking at the current market value of the firm compared to what investors have put into the company
(market value added).2 Such a financial market scorecard is extremely important, but it fails to make a
direct connection to many of the specifics of corporate activity (e.g., asset levels, sales volumes, and
cost figures) that a manager must decide upon. Moreover, proactive managers are paid to create value
for investors not just to wait to see if value was added.
The approach most frequently used by companies to evaluate individual projects is discounted cash
flow, as illustrated by net present value analysis.3 A project’s NPV is a measure of the value the project
creates for the firm’s investors. Positive NPVs thus represent desirable investment opportunities. NPV is
calculated by estimating the incremental cash flows due to the project, taking the present value of those
flows at an appropriate hurdle rate and then subtracting any initial outlay. The hurdle rate is often
estimated as the weighted-average cost of capital appropriate for the risk of the proposed investment.
Such a hurdle rate thus captures investors’ return requirements. NPV analysis looks at the project over a
multiyear horizon to capture all the project’s effects. NPV analysis addresses the question: should we do
this project? It assigns value to decisions not to particular time periods.
The maximization of shareholders wealth is a significant objective of management. According to
Dr.R.Srinivasan,(2010)”Any action which results wealth or which has a net present value is a
preferable one and should be undertaken”. The wealth of the company is based on the
maximization of the present value of the entity. i.e., the present worth of the entity, This wealth
may be measured if the organization has shares that are traded by the public, this because the
market price of the share is indicative of the value of the organization. And to a shareholder, the
word ‘wealth’ is based upon the amount of shareholder’s current dividends and the market price
of share.
Essays, UK. (November 2018). Wealth Maximization and the NPV Method. Retrieved from
https://www.ukessays.com/essays/finance/wealth-maximization-and-the-npv-method-financeessay.php?vref=1
How does the NPV model relate to value creation at a company?
The Net Present Value method automatically uses the Time Value Money concept
which captures the idea in finance that cash received in earlier periods has greater
value than cash received in later periods (AKLearning, 2013).
NPV is used in capital budgeting and investment planning to analyze the profitability of
a projected investment or project. A positive net present value indicates that the
projected earnings generated by a project or investment - in present dollars - exceeds
the anticipated costs, also in present dollars. It is assumed that an investment with a
positive NPV will be profitable, and an investment with a negative NPV will result in a
net loss. This concept is the basis for the Net Present Value Rule, which dictates that
only investments with positive NPV values should be considered (Kenton, 2019).
The following formula is used to calculate NPV:
Net Present Value Formula. Investopedia
In this equation:
Rt = net cash inflow-outflows during a single period t
i = discount rate or return that could be earned in alternative investments
t = number of time periods
If you are unfamiliar with summation notation – here is an easier way to
remember the concept of NPV:
NPV = (Today’s value of the expected cash flows) – (Today’s value of
invested cash)
(AKLearning, 2013) [Interactive tutorial ] [Closed captioned]
Kenton, W. (2019, February 10). Net Present Value (NPV). Retrieved February 19,
2019, from https://www.investopedia.com/terms/n/npv.asp#axzz1nhT0ixOH.
The Net Present Value method automatically uses the Time Value Money concept
which captures the idea in finance that cash received in earlier periods
has greater value than cash received in later periods.
Applying that concept, we were able to value each one of the projects in this case we have one project, one investment that is created value in the company,
and another investment that was planned to not create value to the company.
So, very easy decision is to go forward with one that creates values,
we will not go forward the one that loses value.