Tag Archives | net present value

Discounted Cash Flow vs IRR

See Also:
Net Present Value versus Internal Rate of Return
Discounted Cash Flow Analysis
Internal Rate of Return Method
Net Present Value Method
Free Cash Flow Analysis

Discounted Cash Flow vs IRR

A lot of people get confused about discounted cash flow vs IRR and its relation or difference to the net present value (NPV) and the internal rate of return (IRR). In fact, the internal rate of return and the net present value are a type of discounted cash flows analysis. Both the NPV and the IRR require taking estimated future payments from a project and discounting them into the Present Value (PV). The difference in short between the NPV and the IRR is that the NPV shows a project’s estimated return in monetary units and the internal rate of return reveals the percentage return needed to break even. In fact, the IRR is the return needed for the NPV to hit 0. Further analysis of the difference between the NPV vs IRR can be found in the article NPV vs IRR.

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discounted cash flow vs irr

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Sensitivity Analysis Definition

See Also:
Operating Profit Margin Ratio Analysis
Free Cash Flow Analysis
Cost Volume Profit Model
General Ledger Reconciliation and Analysis
How to Prepare a Break Even Analysis

Sensitivity Analysis Definition

Sensitivity analysis consists of studying the effects of changes in variables on the outcomes of a mathematical model. Furthermore, a model may consist of numerous input variables and one or more output variables. By changing an input variable, and measuring how the outcomes are affected by that change, the analyst can gauge how sensitive the model is to the individual input variable.

Sensitivity Analysis in Business Decision-Making

Use sensitivity analysis in business decision-making. It is a way of measuring and quantifying uncertainty. The analyst can create a model based on the relationships between inputs and outputs. Once the model is set up, the analyst can tweak the inputs to see how the outputs are affected. The analyst can also alter the model to create hypothetical scenarios such as a best case scenario, a worst case scenario, and a most likely scenario.

For example, an analyst might use sensitivity analysis to measure a project’s net present value (NPV) for various expectations of costs, revenues, capital investment, macroeconomic factors, and other relevant variables.

Problems with Sensitivity Analysis

First, the accuracy of the sensitivity analysis depends on the quality of the assumptions built into the model. If the model contains erroneous assumptions, then the output of the sensitivity analysis will be inaccurate. Second, sensitivity analysis may not account for interdependencies among input variables. Finally, the assumptions built into the model may be based on historical data. Therefore, it cannot necessarily be relied upon to predict future results. Also, subjectivity may taint the analysis.

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sensitivity analysis definition, Problems with Sensitivity Analysis, Sensitivity Analysis
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Adjusted Present Value (APV) Method of Valuation

See Also:
Valuation Methods
Net Present Value Method
Internal Rate of Return Method
NPV vs IRR
Capitalization

Adjusted Present Value (APV) Method of Valuation Definition

Adjusted Present Value (APV) Method of Valuation is the net present value of a project if financed solely by equity (present value of un-leveraged cash flows) plus the present value of all the benefits of financing. Use this method for a highly leveraged project.

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Adjusted Present Value Method Calculation

1. Calculate the value of un-leveraged project by discounting the expected free cash flow to the firm at the un-leveraged cost of equity.

2. Then, calculate the expected tax benefit from a given level of debt by discounting the expected tax saving at the cost of debt to reflect the riskiness of this cash flow.

3. Finally, evaluate the effect of a given level of debt on the default risk of a company and expected bankruptcy costs.

Thus, the APV calculation is as follows:

Value of the operating assets = Un-levered firm value + PV of tax benefits – Expected Bankruptcy Costs

Adjusted present value = value of the operating assets + value of cash and marketable securities.

Adjusted Present Value Application

APV method is very similar to traditional discounted cash flow (DCF) model. However, instead of weighted average cost of capital(WACC), cash flows would be discounted at the cost of assets, and tax shields at the cost of debt. Technically, an APV valuation model combined impact of both growth and the tax shield of debt on the cost of capital, the cost of equity, and systematic risk. Thus it is a more flexible way of approaching valuation than other method. However, APV method has some flaws. Company value will be overstated when adding the tax benefits to un-levered company value to get the levered company value, especially for some companies with high debt ratios.

Take some time to read over our Top 10 Destroyers of Value whitepaper before you start your company’s valuation.

Adjusted Present Value (APV) Method of Valuation

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Adjusted Present Value (APV) Method of Valuation

 

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Net Present Value Method

See also:
Valuation Methods
Adjusted Present Value Method
Internal Rate of Return Method
Time Value of Money
Capital Budgeting Methods
Rule of 72

Net Present Value Definition

Net Present Value (NPV) is defined as the present value of the future net cash flows from an investment project. NPV is one of the main ways to evaluate an investment. The net present value method is one of the most used techniques; therefore, it is a common term in the mind of any experienced business person.


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Net Present Value Method Explanation

Net present value can be explained quite simply, though the process of applying NPV may be considerably more difficult. Net present value analysis eliminates the time element in comparing alternative investments. Furthermore, the NPV method usually provides better decisions than other methods when making capital investments. Consequently, it is the more popular evaluation method of capital budgeting projects.

When choosing between competing investments using the net present value calculation you should select the one with the highest present value.

If:

NPV > 0, accept the investment.
NPV < 0, reject the investment.
NPV = 0, the investment is marginal

Net Present Value Discount Rate

The most critical decision variable in applying the net present value method is the selection of an appropriate discount rate. Typically you should use either the weighted average cost of capital for the company or the rate of return on alternative investments. As a rule the higher the discount rate the lower the net present value with everything else being equal. In addition, you should apply a risk element in establishing the discount rate. Riskier investments should have a higher discount rate than a safe investment. Longer investments should use a higher discount rate than short time projects. Similar to the rates on the yield curve for treasury bills.

Other net present value discount rate factors include: Should you use before tax or after tax discount rates? AS a general rule if you are using before tax net cash flows then use before tax discount rates. After tax net cash flow should use after tax discount rate.

Net Present Value Formula

The Net Present Value Formula for a single investment is: NPV = PV less I

Where:

PV = Present Value
I = Investment
NPV = Net Present Value

The Net Present Value Formula for multiple investments is:

The sum of all terms of:

CF (Cash flow)/ (1 + r)t

Where:

CF = A one-time cash flow
r = the Discount Rate
t = the time of the cash flow

Net Present Value Calculation

For a single investment:

$120,000 – $5,000 = $115,000

Where:

PV = $120,000
I = $5,000
NPV = $115,000

For multiple investments:

$120,000 / (1 + 10%)1 = $109,091

Where:

CF = $120,000
r = 10%
t = Year 1
NPV = $109,091

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Net Present Value Advantages

Net present value benefits include the following:

Net Present Value Limitations

Net present value disadvantages include the following:

Net Present Value Example

For example, Jody is the owner of a debt collections firm called Collectco. Jody has been working on his company for several years. As the years have piled up on Jody, so has the urge to retire and live a simpler life. Finally reaching the end of his rope, Jody is ready to move on and spend more time with his children. In order to do this, Jody must sell his company. Adding to this, Jody must first make sure his company is up to date with industry standards. If Jody’s company is not performing to the same efficiency as the industry standard, then he will loose some of it’s value in negotiations with a buyer.

Jody begins by hiring an expert consultant in the industry to conduct an audit on the company. The audit turned out to be much better than Jody expected. But despite this, Jody must update his collections software as it is no longer supported by technical assistance from the creator. Jody performs the net present value calculation to evaluate this investment.

$120,000 – $5,000 = $115,000

Where:

PV = The yearly income of Collectco = $120,000
I = The cost of the new collections software = $5,000
NPV = $115,000

Now, Jody can begin the process of finding a buyer for his company. His consultant, an expert in the business dealings of collections firms, tells him that it is in his best interest to know the Net Present Value of his company before he begins negotiations. So, Jody starts this process by attempting to find the easiest way to perform this calculation. After finding few relevant online results for the search “net present value calculator”, Jody happens to find the NPV formula. Jody then performs the following calculation:

$120,000 / (1 + 10%)1 = $109,091

Where:

CF = Collectco yearly cash flow = $120,000
r = 10%
t = Year 1
NPV = $109,091

With this investment and information, Jody can begin to achieve what he has always dreamed of: a comfortable retirement which allows him to spend time with the people he cares about most. Jody is pleased because all of his efforts are resulting in the life he has worked to gain.

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Net Present Value Method

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Net Present Value Method

Net Present Value Template

An excellent net present value template can be found at the Microsoft Office site here: http://office.microsoft.com/en-us/templates/TC100152681033.aspx

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NPV vs Payback Method

See Also:
Payback Period Method
Bailout Payback Method
Rule of 72

NPV vs Payback Method

NPV (Net Present Value) is calculated in terms of currency while Payback method refers to the period of time required for the return on an investment to repay the total initial investment. Payback, NPV and many other measurements form a number of solutions to evaluate project value.

Payback method, vs NPV method, has limitations for its use because it does not properly account for the time value of money, inflation, risk, financing or other important considerations. While NPV method considers time value and it gives a direct measure of the dollar benefit on a present value basis of the project to the firm’s shareholders. NPV is the best single measure of profitability.

Payback vs NPV ignores any benefits that occur after the payback period. It also does not measure total incomes. An implicit assumption in the use of payback period is that returns to the investment continue after payback period. Payback method does not specify any required comparison to other investments or investment decision making. It indicates the maximum acceptable period for the investment. While NPV measures the total dollar value of project benefits. NPV, payback period fully considered, is the better way to compare with different investment projects. If you’re looking to sell your company in the near future, download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value.

NPV vs Payback method

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NPV vs Payback method

For additional information on NPV, please read Net Present Value Method.

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NPV vs IRR

See also:
Net Present Value Method
NPV Versus Payback Method
Internal Rate of Return Method
Capital Budgeting Methods
Discount Rate
Weighted Average Cost of Capital
Discounted Cash Flow versus Internal Rate of Return (dcf vs irr)

NPV vs IRR

Key differences between the most popular methods, NPV vs IRR (the Net Present Value Method and Internal Rate of Return Method), include the following:

NPV Method

Calculate NPV in terms of currency. Then express IRR in terms of the percentage return a firm expects the capital project to return. Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not.

IRR Method

The IRR Method cannot be used to evaluate projects where there are changing cash flows For example, an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm. However, the IRR Method does have one significant advantage. Managers tend to better understand the concept of returns stated in percentages. They find it easy to compare to the required cost of capital.

NPV vs IRR Comparison

While both the NPV Method and the IRR Method are both DCF models and can even reach similar conclusions about a single project, the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows. This is preferable to a larger project that will generate more cash. Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recommendation.


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Other Variations of NPV vs IRR

Adjusted Present Value (APV)

The Adjusted Present Value (APV) Method is a flexible DCF method that takes into account interest related tax shields. Furthermore, it is designed for firms with active debt and a consistent market value leverage ratio.

Profitability Index (PI)

The Profitability Index (PI) Method, which is modeled after the NPV Method, is measured as the total present value of future net cash inflows divided by the initial investment. This method tends to favor smaller projects. Therefore, it is best used by firms with limited resources and high costs of capital.

Bailout Payback Method

The Bailout Payback Method is a variation of the Payback Method. Furthermore, it includes the salvage value of any equipment purchased in its calculations.

Real Options Approach

The Real Options Approach allows for flexibility and encourages constant reassessment based on the riskiness of the project’s cash flows. It is also based on the concept of creating a list of value-maximizing options to choose projects from. In fact, management can, and is encouraged, to react to changes that might affect the assumptions that were made about each project being considered prior to its commencement, including postponing the project if necessary. It is also noteworthy that there is not a lot of support for this method among financial managers at this time.

Both IRR and NPV are rates which assign value to your company. If you’re looking to sell your company, then download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value.

ROCE

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NPV vs IRR

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Discounted Cash Flow versus Internal Rate of Return (dcf vs irr)

See Also:
Net Present Value versus Internal Rate of Return
Discounted Cash Flow Analysis
Internal Rate of Return Method
Net Present Value Method
Free Cash Flow Analysis

Discounted Cash Flow versus Internal Rate of Return

A lot of people get confused about discounted cash flows (DCF) and its relation or difference to the net present value (NPV) and the internal rate of return (IRR). In fact, the internal rate of return and the net present value are a type of discounted cash flows analysis. Both the NPV and the IRR require taking estimated future payments from a project and discounting them into the Present Value (PV). The difference in short between the NPV and the IRR is that the NPV shows a projects estimated return in monetary units and the internal rate of return reveals the percentage return needed to break even. In fact the IRR is the return needed for the NPV to hit 0. Further analysis of the difference between the NPV vs IRR can be found in the article NPV vs IRR.

If you’re looking to sell your company in the near future, download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value. Don’t let the destroyers take money away from you!

Discounted Cash Flow versus Internal Rate of Return

Strategic CFO Lab Member Extra

Access your Exit Strategy Checklist Execution Plan in SCFO Lab. The step-by-step plan to get the most value out of your company when you sell.

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Discounted Cash Flow versus Internal Rate of Return

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