Net present value (NPV) is not different to discounted cash flow principles. It is the most theoretically sound valuation technique for applying the principles.
The NPV method identifies the amounts of all cash flows and the time period in which occurs (i.e., year 1, year 2, year 3 etc). Once all positive and negative cashflows in a year have been established, the net cashflow in each year is discounted (DCF) by a rate usually based on the required rate of return for the investor. This is done to determine the present value of each year’s cash flow. The initial outlay is then deducted from the total of present value of the future cash flows to determine the NPV of the investment opportunity. NPV gives a dollar value outcome.
A positive NPV indicates the investment is worthwhile in that the positive value is the amount by which the return from the project exceeds the required rate of return, as the numbers have already been discounted by the required rate of return.
A negative NPV suggests the investment should be avoided as the result equals the amount by which the investment fails to deliver the required rate of return.
The general form of the NPV method can be expressed as:
|NPV = – IO + CF1/(1 + i) + CF2/(1 + i)2 + CF3/(1 + i)3|
|+ …. CFn/(1 + n)n|
|where IO = Initial outlay|
|i = Discount rate per period|
|CFx = Cash flow in period x|
|n = Number of periods|
The discount rate applied to future cash flows is also the investor’s required rate of return on the investment. It is the rate of return the investor would require from other investment opportunities of similar risk. Also known as the opportunity cost of the investment, the discount rate chosen is the rate of return required to compensate the investor for:
- The inconvenience of their funds being tied up in the investment
- The expected effect of inflation in eroding the purchasing power of the funds invested
- The risk that the actual cash flows from the investment turn out to be less than expected.
|The discount rate applied to the cash flows from a property investment will generally be greater than that applied to the cash flows from an investment in government bonds.
The discount rate also reflects the financing of the investment. The answer to the above Activity assumes an all-equity financed investment. Hence the risk factor incorporated into the discount rate reflected the risk of the investment project itself.
The discount rate is also a measure of the cost of capital for the project. Where the project is financed wholly by the investor (i.e. all equity is financed), the risk is borne entirely by the investor and so the discount rate is the investor’s required rate of return.
If a property investment is financed by a mixture of debt and equity, then the discount rate will be a weighted average of the costs of each type of finance. Debt finance is cheaper than equity, but it does increase the risk borne by the investor, as the loan provider has a prior claim on the property assets. This would be expected to increase the required rate of return on the equity component.
|Looking at the data in the above example, should the investor accept or reject the proposal and why?|
It is important that you are internally consistent when estimating cash flow and determining the appropriate discount rate. If cash flow estimates are not adjusted to remove the expected inflation component, the discount rate should also include compensation for the loss of purchasing power arising from the expected inflation.
Similarly, if cash flows are estimated on a pre-tax basis, the discount rate should also be a pre-tax discount rate.
The NPV method is a sound valuation technique because it:
- Includes all cash flows arising from the investment
- Takes explicit account of the timing of those cash flows and discounts for the time value of money
- Gives unambiguous results.
The main drawback of the NPV method, in common with all discounted cash flow techniques, is the difficulty in estimating future cash flows. This may not be a serious problem for rental receipts, but it is difficult to estimate future expected sales prices for property assets.