Net Present Value Analysis
The value and, therefore, the price one should pay for any
income producing investment is the present value of the cash flow stream to be derived from it, discounted
by a rate which reflects the risk of owning it in the first place.
In a business setting, when a company is considering a capital
investment such as a building, or heavy equipment, or an investment in any asset which will benefit the
company beyond one accounting period, a process called net present value analysis or discounted cash flow
analysis is necessary.
The process begins with identifying the out of pocket cost
of the investment to be made with after tax dollars. This may not be as easy to do as it first appears.
Complications can arise in replacing and expensive machine with a newer, more efficient one. For example,
if the old machine is salvaged, its cost has to be deducted from the of pocket cost of the new machine.
However, sometimes, the old machine is not fully depreciated under our tax laws and, as such, a tax liability
or a tax credit has to be factored into the computation, depending on what the salvage price is.
When the true out of pocket cost of the asset is determined
it is then necessary to identify the bottom line cash flows from the new machine, and compare them with
the existing machine to determine the "relevant cash flow difference". In other words, since the company
already owns the existing cash flows from the old machine, what they are buying is simply the cash
flow difference. This process of establishing cash flows involves revenue, expense, depreciation,
and taxes and, therefore, a spreadsheet application is required.
Once the cost of the investment and the net after tax cash
flows are clearly identified, then the process of evaluation can begin. Going back to the opening paragraph,
whether the investment should be made depends on whether the present value of the bottom line cash flows
exceed the bottom line investment, when such cash flows are discounted to the present by percentage cost
of getting the money. This is a universally applied corporate standard of investment evaluation.
Using a simple example, if a company were to buy a delivery
truck which costs $30,000, and it could show additional bottom line cash flows of $10,000 per year from
such a vehicle for 5 years, if its cost of capital was 10%, then $10,000 x 3.79079 (the present value
of annuity factor) would equal $37,909. Therefore the purchase of that truck would be warranted since
the company is spending $30,000 in present value dollars to receive $37,900 in present value dollars in
return. The excess $7,900 is called net present value and, since it is a positive number, the investment
will have a positive impact on the business' value.
One word about the discount factor. The discount factor properly
applied in such circumstances is the weighted average cost of capital of the company. This is the
weighted average percentage return required by all the stakeholders on the right hand side of the balance
sheet, weighted by the book or market value of each individual percentage cost.