Review Of The Basics

Vegetron's chief financial officer (CFO) is wondering how to analyze a proposed $1 million investment in a new venture called project X. He asks what you think.

Your response should be as follows: "First, forecast the cash flows generated by project X over its economic life. Second, determine the appropriate opportunity cost of capital. This should reflect both the time value of money and the risk involved in project X. Third, use this opportunity cost of capital to discount the future cash flows of project X. The sum of the discounted cash flows is called present value (PV). Fourth, calculate net present value (NPV) by subtracting the $1 million investment from PV. Invest in project X if its NPV is greater than zero."

However, Vegetron's CFO is unmoved by your sagacity. He asks why NPV is so important.

Your reply: "Let us look at what is best for Vegetron stockholders. They want you to make their Vegetron shares as valuable as possible."

"Right now Vegetron's total market value (price per share times the number of shares outstanding) is $10 million. That includes $1 million cash we can invest in project X. The value of Vegetron's other assets and opportunities must therefore be $9 million. We have to decide whether it is better to keep the $1 million cash and reject project X or to spend the cash and accept project X. Let us call the value of the new project PV. Then the choice is as follows:

Asset

Market Value ($ millions)

Reject Project X

Accept Project X

Cash

1

0

Other assets

9

9

Project X

0

PV

10

9 + PV

Brealey-Meyers: I I. Value I 5. Why Net Prsnt Value I I © The McGraw-Hill

Principles of Corporate Leads to Better Companies, 2003 Finance, Seventh Edition Investments Decisions than Other Criteria

92 PART I Value

FIGURE 5.1

The firm can either keep and reinvest cash or return it to investors. (Arrows represent possible cash flows or transfers.) If cash is reinvested, the opportunity cost is the expected rate of return that shareholders could have obtained by investing in financial assets.

Investment opportunity (real asset)

Cas

h

1

Investment opportunities (financial assets)

Invest

Alternative: pay dividend to shareholders

Shareholders invest for themselves

"Clearly project X is worthwhile if its present value, PV, is greater than $1 million, that is, if net present value is positive."

CFO: "How do I know that the PV of project X will actually show up in Veg-etron's market value?"

Your reply: "Suppose we set up a new, independent firm X, whose only asset is project X. What would be the market value of firm X?

"Investors would forecast the dividends firm X would pay and discount those dividends by the expected rate of return of securities having risks comparable to firm X. We know that stock prices are equal to the present value of forecasted dividends.

"Since project X is firm X's only asset, the dividend payments we would expect firm X to pay are exactly the cash flows we have forecasted for project X. Moreover, the rate investors would use to discount firm X's dividends is exactly the rate we should use to discount project X's cash flows.

"I agree that firm X is entirely hypothetical. But if project X is accepted, investors holding Vegetron stock will really hold a portfolio of project X and the firm's other assets. We know the other assets are worth $9 million considered as a separate venture. Since asset values add up, we can easily figure out the portfolio value once we calculate the value of project X as a separate venture.

"By calculating the present value of project X, we are replicating the process by which the common stock of firm X would be valued in capital markets."

CFO: "The one thing I don't understand is where the discount rate comes from."

Your reply: "I agree that the discount rate is difficult to measure precisely. But it is easy to see what we are trying to measure. The discount rate is the opportunity cost of investing in the project rather than in the capital market. In other words, instead of accepting a project, the firm can always give the cash to the shareholders and let them invest it in financial assets.

"You can see the trade-off (Figure 5.1). The opportunity cost of taking the project is the return shareholders could have earned had they invested the funds on their own. When we discount the project's cash flows by the expected rate of return on comparable financial assets, we are measuring how much investors would be prepared to pay for your project."

Brealey-Meyers: I I. Value I 5. Why Net Prsnt Value I I © The McGraw-Hill

Principles of Corporate Leads to Better Companies, 2003 Finance, Seventh Edition Investments Decisions than Other Criteria

CHAPTER 5 Why Net Present Value Leads to Better Investment Decisions Than Other Criteria 93

"But which financial assets?" Vegetron's CFO queries. "The fact that investors expect only 12 percent on IBM stock does not mean that we should purchase Fly-by-Night Electronics if it offers 13 percent."

Your reply: "The opportunity-cost concept makes sense only if assets of equivalent risk are compared. In general, you should identify financial assets with risks equivalent to the project under consideration, estimate the expected rate of return on these assets, and use this rate as the opportunity cost."

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