Iycee Charles de Gaulle Summary Valuation Methods Essay

Valuation Methods Essay

Valuation Methods

NPV (Net Present Value), or also known as NPW (net present worth) is the totality of the PV (Present value) of the cash flows’ time series (Lin and Nagalingan 2000). It utilizes the time value of money as a standard method of apprising projects, especially long term ones. It is widely used in the field of economics, especially in capital budgeting as it attempts to measure any surplus or deficit in cash flows in terms of present value.

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Formula of NPV is as follows:

NPV indicates the value and the significance of a certain project or investment added to the firm or organization’s value. An NPV that has positive results mean that the benefits of the project, investment or transaction exceed the costs associated with these projects. The value of the buyer increases along with the wealth of the shareholders once the project is undertaken. A negative NPV indicate that the cost of the project or transaction exceeds its benefits and undertaking the project would decrease shareholder wealth and the value of the buyer. If the NPV is equal to zero, the projects costs are equal to its benefits, thus, it has no impact on the value or wealth of the shareholders.

There have been several criticisms regarding the use of IRR compared to NPV that can be found in textbooks on financial management (Weston and Thomas 1992). The IRR Internal Rate of Return) indicates the efficiency and effectiveness of a certain investment as opposed to NPV which signify the worth or value of a project or investment. The IRR is said to be the discount rate upon which the NPV of cash flows in the future is equal to zero.

If the IRR of a proposed project or investment is greater than the return rate that may be earned through other investments that pose an equal amount of risk indicates that the former is a sound and good proposition. Therefore, the IRR is generally compared to other capital costs, including a suitable risk premium. A greater IRR than the capital cost of a project (also known as the hurdle rate) signifies that the project or investment will lend additional value in the company’s favor.

            The MIRR (Modified Internal Rate of Return) is a determination of the appeal and influence of a certain investment or project. An adaptation from the concept of IRR, the MIRR is utilized during the process of capital budgeting in order to categorize several alternatives and options. Its main difference from IRR lies on the fact that is a measurement of the return rate on the total capital for the whole project duration or time frame.

            In the valuation method of MIRR, it is assumed that all cash flows that are positive are reinvested for the remaining project duration or timeframe. Cash flows that are negative are included in the outlay of the initial investment. Accordingly, the MIRR categorizes the efficiency of projects as consistent with their worth ratio at present, which is another variant of the discounted negative cash flow or NPV. This characteristic of the modified internal rate of return has been considered as the gold standard in several textbooks on the field of finance.

References:

Brealey, R. Myers, S. and Allen, F (2004). Principles of Corporate Finance. McGraw-Hill Higher Education;

Lin, Grier C. I.; Nagalingam, Sev V. (2000). CIM justification and optimisation. London: Taylor & Francis, p. 36

Stermole, F and Stermole, J (2006). Economic Evaluation and Investment Decision Methods. Eleventh edition, Investment Evaluations Corporation

Weston, JF and Thomas, E (1992). Managerial Finance, Ninth Edition. Fort Worth: The Dryden Press, p. 309-320.