Question

"This course argued that the goal of financial management is to create value for the stockholders. The financial manager must thus examine a potential investment in light of its likely effect on the price of the firm's shares. "Explain in a widely used procedure for the difference between an investment's market value and its cost.

Answer 1

The widely used procedure for the difference between an investment's market value and its cost is the net present value method. Net present value simply put is the value generated by undertaking the investment and this in real sense creates value for the stockholders. Capital budgeting is a process that involves searching for those investment projects that generate the highest positive NPV. A positive NPV is to mean that the expected cash flows from the project outweigh the initial investment. NPV calculation is pretty straight forward. It involves estimating the future expected cash flows and the discount rate for the cash flows i.e. to get the cash flows measured in current money terms. Discount rate is usually the opportunity cost rate at which this particular investment is chosen over the other. The important consideration here is that the discount rate has to be reliable and cash flows to be forecasted with accuracy. Also, there is a risk in this method that if the estimates are not correctly taken the method may not serve any purpose and can lead to bad investment decisions as well at times.