Question

How is the net present value (NPV) calculated for a project with a conventional cash flow pattern, and what are the acceptance criteria for NPV, how are they related to the firm’s market value with explanation of the similarities and differences between NPV, PI, and EVA.

PLEASE MINIMUM 350 WORDS.

Answer 1

Net Present Value is the cumulative value of all the future and present cash flows (positive and negative), over the entire lifecycle of the project.

Net Present Value (NPV) is calculated by discounting the cash flow over a discount rate. It is calculated as

NPV = (cash flow 1/ (1+discount rate)) + (cash flow 2 / (1+discount rate)^2) - initial investment.

It accounts for the time value of money.

Acceptance criteria for NPV

The NPV analysis is used to determine how much is the cash flows worth for in the present time. This helps in identifying the cash flow' present values and decide whether it is a good decision to go ahead with a particular project or now, at least based on the financial factors.

Linking with the firm's market value

If the firm goes ahead with projects, that does not show consistent and strong cash flow in future, it does not showcase a positive outlook for the company. This leads to the dwindling market cap for the firm. A consistent cash flow, indicates that the company would continue building good products and services and expects the cash flow to keep coming in. Thus the company's economic health could be derived from the NPV of all the cash flows put together.

Similarities and differences between NPV, PI and EVA (PI is profitability index)

The NPV and PI considers the time value of money and results in the go/no-go decision for a project. The difference lies in the fact that PI could be useful in deciding if we should go ahead with a project with limited funds.

EVA and NPV are closely related and result in similar estimation of the valuation of the firm. Both use the same approaches - cash flows and cost of capital over time. EVA enables top management responsible for measuring control on the return on capital and the effects of their decisions on the cost of capital.