AboutMike Weikle Expertise Banking Lender Liability; Insurance Coverage; Consumer Rights; Bank Fraud; Criminal: White
Collar Crime; Fair Debt Collection Practices Act; Directors and Officers Liability
Experience Commissioned National Bank Examiner 7 years; President of Two Community Banks; Division Claims Specialist for American Bankers Association Sponsored Insurance Program; Carter Member of the Bank Fraud Team of the Office of the Comptroler of the Curency "OCC" (National Banjk Examiners); Attorney previously representing FDIC and Resolution Trust Corporation as well as consumers and commercial borrowers in claims against the banking industry; Former Data Processing Systems Examiner for the OCC; Expert Witness on variety of banking issues in both state and federal court.
Education/Credentials Certified Public Accountant;
JD -- West Virginia College of Law - Order of the Coif
Data Processing Training Old Dominion Bank and IBM
The first I wanted to ask you is that during investment appraisals the NPV and IRR techniques assumes tomorrow’s money has less value than today…..is this always true?
Secondly will you please tell me why IRR approach is not always give good assessment?
Thirdly during calculating appropriate discount rate for investment appraisal how to get a risk premium over the cost of capital for an investor let say who finance his project by borrowing from band and own equity?
I appreciate your assistance,
Hiwot
Answer NPV and IRR techniques assumes tomorrow’s money has less value than today…..is this always true?
To date, any period of deflation (if there ever has been any measurable period of deflation+, has not been significant. As a result of inflation, historically, what you can purchase for $1.00 today, will cost more than $1.00 by the next year. As such, historically, money can always buy more over-all today than it will purchase in the future.
While net present value (NPV) calculations have some utility when you are valuing investment opportunities, the process is not perfect by any means.
The biggest disadvantage is the NPV's sensitivity to discount rates. NPV computations are actually a mere summation of multiple discounted cash flows - both positive and negative. The discounted cash flows are then converted into present value terms for the same point in time (usually when the cash flows begin). As such, the discount rate used as the denominator in the calculation of present value (PV) is critical in making an assessment of the final NPV number will be. The disadavantage lies in the fluctuation of discount rates. At present, discount rates are low, however, in an inflationary economy (which is considerable with all the government money going into the economy to stimulate it)even small increase or decrease in the discount rate will have a considerable effect on the final output.
For example: If you were trying to value an investment that would cost you $8,000 up front today, but was expected to pay you $2,000 in annual profits for five years (for a total nominal amount of $10,000), beginning at the end of this year. If you use a 5% discount rate in your NPV calculation, your five $2,000 payments are equal to $8,669.00 in today's dollars. Subtracting the $8,000 initial payment, you are left with an NPV of $669.00. (To learn more about calculating NPV, you should consider reading: Understanding The Time Value Of Money and Anything But Ordinary: Calculating The Present And Future Value Of Annuities.)
However, if you increase the discount rate from 5% to 10%, you get a very different NPV result. At a 10% discount rate, your investment's cash flows add up to a present value of $7,582. Subtract the $8,000 initial cost from this amount, and you're left with a negative NPV of $418.00. Simply by adjusting the rate, you have gone from having an investment that creates $669.00 of value to having one that loses $418.00 instead.
If 5% is the correct rate to use you will take it, and reject it if 10% is the correct rate. But knowing which discount rate to use to accurately predict a percentage number to an investment to represent its risk premium is not an exact science. If the investment is very safe, with low risk of loss, 5% may be a reasonable discount rate to use, but what if the investment has enough risk to warrant a 10% discount rate? Bottom line, NPV calculations require a discount rate, there is no way to get around this issue; therefore, it is a big disadvantage to the NPV methodology.
Making matters even more complex is the reality that your investment likely won't have the same level of risk throughout its entire time horizon. You can try to use different discount rates for each time period, but this makes your investment model even more complex and requires a great deal of effort on your part to peg not only one discount rate accurately, but the next four. This is huge disadvantage to using the NPV model.
Another huge disadvantage of using NPV as an investment criterion is that it wholly ignores the value of any real oportunities that may exist within the investment. Consider again a startup company, which is currently losing money but is expected to have the opportunity to expand greatly in three years' time. If you know the company has this opportunit for expansion in the future, you should incorporate the value of that opportunity into the total NPV of the investment.
While, NPV is a useful starting point to value investments,it is not a definitive answer the investor can rely on for all investment decisions.
Why is the IRR not a good methodology to use in valuing an investment?
Both NPV and IRR are primarily used in capital budgeting, the process by which companies determine whether a new investment or expansion opportunity is worthwhile. Given an investment opportunity, a firm needs to decide whether undertaking the investment will generate net economic profits or losses for the company.
Thus to do this, the investor estimates the future cash flows of the project and discounts them to present value amounts using a discount rate that represents the project's cost of capital and its risk. Next, the investment's future positive cash flows are calculated and one present value number is determined. Next: Subtract this number from the initial cash outlay required for the investment provides the net present value (NPV) of the investment.
Let's illustrate with an example: suppose MDW Company wants to buy a small company. MDW determines the future cash flows generated by the small company, when discounted at a 12% annual rate, yields a present value of $23.5 million. If the small company's owner is willing to sell for $20 million, then the NPV of the project would be $3.5 million ($23.5 - $20 = $3.5). The $3.5 million dollar NPV represents the intrinsic value that will be added to MDW if it undertakes this acquisition.
So, MDW's project has a positive NPV, but from a business perspective, the investor should also know what rate of return will be generated by this investment. To do this, the investor would simply recalculate the NPV equation, this time setting the NPV factor to zero, and solve for the now unknown discount rate. The rate that is produced by the solution is the project's internal rate of return (IRR).
For this example, the project's IRR could, depending on the timing and proportions of cash flow distributions, be equal to 17.15%. Thus, MDW, given its projected cash flows, has a project with a 17.15% return. If there were a project that MDW could undertake with a higher IRR, it would probably pursue the higher-yielding project instead. Thus, you can see that the usefulness of the IRR measurement lies in its ability to represent any investment opportunity's return and to compare it with other possible investments.
To learn more, read: Taking Stock Of Discounted Cash Flow, Anything But Ordinary: Calculating The Present And Future Value Of Annuities and Investors Need A Good WACC.
