NPV, A TOOL TO DECIDE HOW INVEST OUR MONEY

NPV, A TOOL TO DECIDE HOW INVEST OUR MONEY

Always when we have saving in banks or we expect to have an extraordinary income of money (bonuses, earnings participation or cash heritage), we start wondering, what can we do with the money? It is better opening or keeping the money in a bank account? Should I buy a property, like a house or a car? Should I invest the money in a new or existing business? All these questions come in mind and most of persons do not have the necessary tools to find out a proper answer, what we should do with our own money.

The main objective of invest your money is at least, have the same quantity of money at the end of the investment period or in an optimistic approach, have the higher possible profits, in an ideal economic world, our money will be always the same, as we know this is not true, quantity is not the same than value, people see the value of their money is always decreasing, affecting by inflation or other factors, in the past, we as Peruvians, had an inflations experience and know very well how it works and the consequences in our pockets. So, one important thing to take in mind is the cost or price of the money that we can use in an investment.

According to Jaime Pratt, “Money like any other resource has a price. Individuals wishing to borrow money must pay this price, and those who lend it receive this price. The price of money is called interest and is usually expressed as a percentage rate over a certain money period”. Reading this, we can say this price is always negative or dangerous for our investments, if we have the money in a bank, we shall analyze if it is a good idea take out this money or keep it safe in the bank, if we do not, we need to ask for the money in order to get the funds to make possible our investment and need to consider the “price” of this money to calculate our activities. At this point, we need to have a tool to decide what we can do to have the higher benefits.

 According to Harold Bierman, a tool to decide our investments is the Net Present Value, he says “The recommended accept-or-reject criterion is to accept all independent investments whose net present value is greater than or equal to zero, and to reject whose net present value is less than zero”

A project Net Present Value (NPV) equals the sum of its cash inflows and outflows, discounted at a rate, this rate consider the investment’s risk. It is a simple way to see if out investment idea is enough good to give us a profit or at least do not lose money in a period of time.  According to Belverd Needles, “A significant advantage of the NPV method is that it incorporates the time value of money into the analysis of proposed capital investments, Future cash inflows and outflows are discounted by the company’s minimum rate of return to determine their value. The minimum rate of return should at least equal the company´s average cost of capital”

Together with the NPV, one other factor that we shall analyze is the internal rate of return, this is a rate of return used to measure and compare the convenience of an investment.

According to Siu-Lam Tang, “The internal rate of return can be defined as the discount rate i that the net present worth of a project is zero if such i is used in the equivalence calculation.”

Saying this, a good way to find out if our investments ideas are good enough to create earnings, is calculate the net present value, this should be greater than zero if we want profits. Also the IRR must be analyzed, it should be greater that discount rate, using these 2 concepts we can understand better the potential of our proposal investment. According to Zahirul Hoque, “NPV and IRR are the two main discounted cash flow (DCF) methods. Boths measure cash inflows of projects and compare them as if occurring at a single point in time. DCF methods are theoretically superior to other techniques because they recognize the time value of money and that investments have an opportunity cost foregone”

CASE

PROBLEM

The Amazon company is evaluating 2 proposal for a new project, the cost of investment for project A will be $50,000 and for project B will be $63,000, to get undertaking started. For the first project the cash flow will be uniform till the end. The project B proposal will generate cash flows of $45,000 in its first year and $15000 per year in the next four years. Besides, we have to consider for each of the two projects the cost of opportunity between 10 and 15%.

MAIN OBJECTIVE:

Analyze the given data and determine which of the projects will be profitable.

SPECIFIC OBJECTIVE:

Made the evaluation of each of the projects based on their net present value  (NPV) and the internal rate of return (IRR), considering the rate of discount given for the two scenarios. With the results we got we should be able to advice to the Amazon company to take the decision between the project A and B, selecting the one which will return higher profits to the company.

ANALYSIS

RESULTS

Amazon has to analyzed the two proposals, evaluate the variables make the analysis and measured the factors that will determine which of the projects will be the best investment option. Even when in the second project we could get apparently our investment recovered in the two first years, after we measured the Net Present Value with different rate of cost of opportunity for each project we got that the NPV is greater than zero, both projects shows positives values of NPV therefore would be acceptable for the company but our best option for investment will be the project A because our profit is higher. Besides, we evaluated our Internal rate of return for each project and the results confirm us that our best option will be the project A because our IRR is greater than the cost of capital, therefore, the company will earn more than the required return.

...