Positive Net Present Value Investments
Positive net present value investments are those where the
present value of the expected cash flow stream from the project exceeds the present, out- of-pocket cost
of the investment.
One of the major annual financial problems encountered by
financial managers is what assets to invest in over the coming years, to protect corporate market share
and grow the business. This may involve labor saving technology, creative uses of the Internet, buying
a new building, or opening facilities in foreign countries, all of which require huge sums of money gathered
from the available financial markets.
The key to increasing corporate value is success in identifying
these opportunities. Identification of opportunity involves a process called "capital budgeting", where
the financial manager compiles a menu of of possible investments and then carefully selects those projects
which show the greatest promise of optimizing share value. This project is implemented by what is called
an Investment Opportunity Schedule which shows, in graph form, all the projects available, their prospective
internal rates of return, the amount of capital they will require, and the cost of such capital.
These are the key elements of the process: no project should
be acceptable the cash flows from which, when discounted to the present, does not exceed the percentage
cost of obtaining the funds to buy them. Under our system of corporate governance, the common shareholder
is the residual owner. All investment which have earnings in excess of cost (positive net present values)
redound to the benefit of such common shareholder, and tend to increase share value. On the other hand,
any investment which has a negative net present value reduces share values and the overall value of the
Thus the key to all long term asset purchases is that the
dollars returned from them, on an annual basis over the years, must present value at the percentage cost
of securing the funds, to an amount in excess of the out of pocket cost of the investment. No investment
is acceptable which does not meet that criteria.
The process of Net Present Value requires the ability to
accurately estimate gross cash flows from the investment. Several statistical tools such as regressions,
and moving average techniques, are available to do this. It also requires the ability to evolve net cash
flows, using "after tax" criteria and applying the accounting rules with respect to depreciation methods
and the identification of applicable" non cash charges".
When the out of pocket cost of the investment has been identified,
and the net cash flows have been determined, the company's percentage cost of capital must be determined.
This process is predicated on the idea that the discount factor to be applied to any new investment is
the weighted average percentage cost required by all financial interests on the right hand side of the
balance sheet, for all existing funds, and the market cost of capital for each new security necessary
to buy that particular investment.