## Estimating Net Present Value

Imagine we are thinking of starting a business to produce and sell a new product, say, organic fertilizer. We can estimate the start-up costs with reasonable accuracy because we know what we will need to buy to begin production. Would this be a good investment? Based on our discussion, you know that the answer depends on whether or not the value of the new business exceeds the cost of starting it. In other words, does this investment have a positive NPV?

This problem is much more difficult than our "fixer upper" house example because entire fertilizer companies are not routinely bought and sold in the marketplace, so it is essentially impossible to observe the market value of a similar investment. As a result, we must somehow estimate this value by other means.

Based on our work in Chapters 5 and 6, you may be able to guess how we will go about estimating the value of our fertilizer business. We will first try to estimate the future cash flows we expect the new business to produce. We will then apply our basic discounted cash flow procedure to estimate the present value of those cash flows. Once we have this estimate, we will then estimate NPV as the difference between the present value of the future cash flows and the cost of the investment. As we mentioned in Chapter 5, this procedure is often called discounted cash flow (DCF) valuation.

To see how we might go about estimating NPV, suppose we believe the cash revenues from our fertilizer business will be \$20,000 per year, assuming everything goes as expected. Cash costs (including taxes) will be \$14,000 per year. We will wind down the business in eight years. The plant, property, and equipment will be worth \$2,000 as salvage at that time. The project costs \$30,000 to launch. We use a 15 percent discount rate on new projects such as this one. Is this a good investment? If there are 1,000 shares of stock outstanding, what will be the effect on the price per share of taking this investment?

discounted cash flow (DCF) valuation

The process of valuing an investment by discounting its future cash flows.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

IV. Capital Budgeting

9. Net Present Value and Other Investment Criteria