Question 1: Explain the theoretical rationale for the NPV approach to investment appraisal and compare the strengths and weaknesses of the NPV approach to two other commonly used approaches. (30 marks)
This first section of this paper will provide a brief explanation on theoretical rationale for the net present value (NPV) method of investment appraisal and then compare its strengths and weaknesses to two alternative methods of investment appraisal, those of internal rate of return (IRR) and pay-back.
Theoretical rationale for the NPV approach
The net present value rule or NPV devised by Hirshleifer (1958), is the fundamental model of how firms decide whether to invest in a project, commonly known as the ‘investment decision’, or ‘capital budgeting decision’.
With the assumption that a firm’s objective is to maximise shareholder wealth through maximising a company’s market value, firms allocate resources to their most productive use, therefore responding to the needs of stakeholders. As derived by Fisher (1930), when ‘perfect capital markets’ exist (see below for conditions), when a firm only chooses projects with a positive NPVs, they will maximise shareholder wealth.
The following conditions for perfect capital markets are:
- Same capital market interest rates, returns and prices for all - Free and equal access to capital markets
- No participants have any market power over prices
- All participants have the same information
- No taxes that distort economic decisions
Fisher’s separation theorem states that the firm’s investment decision is independent of the preferences of the owner, and that investment decision is independent of the financing decision. This means that investment and financing decision can be separated out, and that the type of owner the firm has does not need to be accounted for when making investment decisions (e.g. the firm does not have to invest with low risk because it has risk averse owners). This theory gives rise to the NPV concept, due to its implication that any real investment should be measured against an equivalent market based investment, the ‘value’ of a project can be defined as the expected discounted future cash flows of the project, where appropriate market based discount rates are used.
The net present value of a project is the difference between the value of the project (discounted future cash flow) and the cost of the project (investment), and is a measure of the ‘value added’ or ‘net contribution’ of the project.
A key theoretical rationale for NPV centres on the ‘time value of money’ principle, namely that holders of money have the option to consume now (i.e. spend) or delay consumption to a later date through investing (i.e. saving). The reward for saving is the interest received on the investment, the amount dependant on the interest rate and timing delay. An investor’s choice to balance present (commonly in the form of in-year dividends) and future consumption (share value growth or future dividends) is commonly known as their ‘indifference’, or their personal preference for immediacy of consumption.
For either investor (immediate or delayed consumption), given the condition of perfect capital markets (above), both would benefit from a firm’s investment in a positive NPV project. The example based on Brealey, Myers & Allen (2008), explains this.
With two investors, F who wants to save for the future and N, who would prefer to spend now. Each has been offered the opportunity to invest £180,000 in a 50% share in a garage that will provide a definite £200,000 return next year. At an interest rate of 5% and a period of t+1, both investor preferences are satisfied by the investment.
- F receives £210,000 at time year 1 (£200,000 x 1.05) - N consumes £200,000 at year 0, by borrowing at an interest rate of 5% and spending up to £210,000 / 1.05
By not investing:
- Both have the option to consume...
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