Net Present Value AnalysisNet present value (NPV) is a superior investment appraisal tool. It seeks to measure by how much an investment increases the shareholder’s wealth in absolute value and in today’s terms (Dobson, 1997). It incorporates the all important concept of time value of money. This concept appreciate that a dollar received today is worth more than a dollar received tomorrow. This concept is incorporated in the net present value calculation by a process called discounting; this is done by multiplying future values by a discounting factor based on the discount rate (Dobson, 1997). The discount rate represents the cost of capital.
In the case study of Elgar Pharmaceutical Ltd, the discount rate is 12%. This was arrived at based on the assumption that the tax rate is 20% per annum and that the bank’s interest rate of 15% is the pre-tax cost of debt. Since interest on bank loans is tax allowable, then a post-tax cost of debt must be calculated. This is done by multiplying the interest rate by, one minus the tax rate (interest rate * (1-interest rate) giving a rate of 12%.
From the discount rate a discount % is calculated, by adding one to the discount rate then raised to the power of time in years. In this case (1+12%) ^-1, this gives an annuity factor of 0.893 (rounded off). This figure can be obtained directly from the present value table in the column with12% and the row with year one. For the purpose of analyzing Elgar Pharmaceutical Ltd’s investment, it is assumed that the post-tax cost of debt is equal to the company’s weighted average cost of capital and thus it is an appropriate discount rate.
It is assumed that the whole of the initial capital outlay is to be incurred now/time zero. This eliminates the need to discount the $ 400,000 cash outflow. It is normal for capital investments to attract capital allowances in terms of tax benefits but this has been ignored in this analysis. Assuming that scenario one prevails (ignoring probabilities). The worth of the business in one year’s time will be $ 700,000; however this has been given in future value terms.
To find the present value, this figure is multiplied by the annuity factor 0.893. This gives $ 625,000 as the worth of the firm in present value terms. To find the net present value we deduct the initial outlay of $ 400,000 from the present value to give the net present value as positive $ 225,000. This would translate to investor’s wealth increasing by $ 225,000, this mean that the investment is worthwhile. Assuming scenario two prevails (ignoring probabilities). The only change in the data from scenario one is the worth after one year which change to $340,000.
This is discounted using the discount rate of 12% (discount factor 0.893) to give a present value of negative $ 96,428.57. This means that if the value of the business is to be $ 340,000 in one year’s time, the shareholders will have lost $ 96428.57. This would make this investment not to be worthwhile and it should be rejected. Application of Expected Values in the Investment Appraisal