Question

"We can calculate future cash flows precisely and obtain an exact value for the NPV of an investment." Explain. Do you agree or disagree with the statement ? a new answer please.

Answer 1

"We can calculate future cash flows precisely and obtain an exact value for the NPV of an investment."

We disagree with the given statement.

Explanation: -

The Net Present Value (NPV) analysis is a form of intrinsic valuation and is used help determine how much an investment, project, or any series of cash flows is worth. NPV is the value of all future cash flows (positive and negative) over the entire life of an investment discounted to the present. It is an all-encompassing metric, as it takes into account all revenues, expenses, and capital costs associated with an investment in its Free Cash Flow (FCF). The Free Cash Flow (FCF) represents the amount of cash flow from operations available for distribution after depreciation expenses, taxes, working capital, and investments are accounted for and paid.

The FCF can be computed using various methods as below -

1. ​FCF = NI+NC+(I×(1−TR))−LI−IWC
   • where: NI=Net income; NC=Non-cash charges; I=Interest; TR=Tax Rate; LI=Long-term Investments; IWC=Investments in Working Capital​
2. FCF = CFO+(IE×(1−TR))−CAPEX
   • where: CFO=Cash flow from operations; IE=Interest Expense; CAPEX=Capital expenditures​
3. ​FCF = (EBIT×(1−TR))−D−LI−IWC
   • where: EBIT=Earnings before interest and taxes; D=Depreciation​
4. ​FCF = (EBITDA×(1−TR))+(D×TR)−LI−IWC
   • where: EBITDA=Earnings before interest, taxes, depreciation and amortization​

Thus, the future cash flows are dependent on atleast 4 major factors, which are the Net Income, the Interest expenses, the Investments made and the Tax rates applicable.

In calculating the future cash flows precisely, we must ensure the accuracy of all of these factors. For a well-established company, in a non-volatile industry, these factors are generally accurately predictable, if a robust deterministic analysis is made. However, in conditions that are more volatile, i.e.. in an industry where the rates of interest or the expected earnings cannot be predicted correctly, or if there is no advance knowledge to the the analysts regarding the expected probability of the returns (e.g.. when investing in a completely new sector), the forecasting of the NPV may be a more difficult exercise.  

In addition to factoring all revenues and costs, the NPV also takes into account the timing of each cash flow in order to to adjust for the risk of an investment opportunity, and to account for the time value of money (TVM) that can result in a large impact on the present value of an investment. Thus, to accurately predict the NPV of an investment, it is also necessary to understand the level of risk in the opportunity as well as the probable impact of time due to inflation, interest rates, and opportunity costs.

With reference to the above issues, it can be concluded that it is not always possible to precisely compute the future cash flows to provide an exact NPV of an investment, since there are a large number of underlying factors to both computations. However, with due diligence and prudent forecasting, it is definitely possible to arrive at an approximately accurate figure of both FCF and NPV, to guide the investment making decisions.