Net Present Value(NPV) Analysis
We know that if we want to know the net present value (NPV) of an asset (whether this is a physical asset such as a machine or a financial asset such as a share in a business) we must discount the future cash flows generated by the asset over its life. Thus:
where C1, C2, C3 and Cn are cash flows after one year, two years, three years and n years, respectively, and r is the required rate of return.
Shareholders have a required rate of return, and managers must strive to generate long-term cash flows for shares (in the form of dividends or proceeds from the sale of the shares) that meet this rate of return. The expectation that the managers will, in the future, fail to generate the minimum required cash flows will have the effect of reducing the value of the business as a whole and, therefore, of the individual shares in it. If a business is to create value for its shareholders, it must be expected to generate cash flows that exceed the required returns of shareholders. We should bear in mind here that the value of a business and its shares is entirely dependent on two factors:
1 expectations of future cash flows; and
2 the shareholders’ required rate of return.
Past successes are not relevant.
The NPV approach fulfils the criteria that we mentioned earlier as a means of fairly assessing changes in shareholder value because:
· It considers the long term. The returns from an investment, such as shares, are considered over the whole of its life.
· It takes account of the cost of capital and risk. Future cash flows are discounted using the required rates of returns from investors (that is, both long-term lenders and shareholders). Moreover, this required rate of return will reflect the level of risk associated with the investment. The higher the level of risk, the higher the required level of return.
· It is not sensitive to the choice of accounting policies. Cash rather than profit is used in the calculations and is a more objective measure of return.