Here is a small recap for all of you who have missed our earlier school articles on investing and time value of money.
Investment is essentially a matter of putting your savings into an asset (bank deposit, bonds, debentures, shares, real estate etc) with the expectation of receiving a larger sum in the future. Since the future is not certain there is risk in the investment for which investors will wish compensation through time value of money.
That makes intuitive sense, doesn't it?
Lets try a small quiz.
If you invest today, a sum of Rs.100 in a post office at the rate of 10% compounded annually for 2 years then how much cash you will receive after two years?
What? You said very simple! And your answer is Rs. 121. Brilliant!
Now, lets try a tricky one.
If the same post office promises you to pay Rs.121 two years from today and the rate of interest is same at 10% compounded annually then how much money he will ask you to deposit? Yes, you got it - it is the same Rs. 100. But let us check the science behind it.
As you know, Rs.100 today is worth more than Rs. 100 tomorrow, because of the inflation and the investment risk i.e. the risk you take in investing this Rs.100. This is called the "Time Value of Money"
In our example above, Rs. 100 that you deposited in the post office is your principal investment. The interest rate of 10% is the "time value of money". When you answered Rs.121 as the money you will receive after 2 years, you added the time value of money to your original investment. But when you know the amount (cash flow) you will receive after two years then you need to remove this time value of money from that amount to get the fair price, also known as present value, you should invest. This method of finding the present value is known as Cash Flow Discounting and the time value of money is called the discount factor.
Cash flow discounting is the backbone of all financial analysis. Why?
All project decisions are based on the cash flow discounting. As a matter of fact, this cash flow discounting is the prerequisite that must be used in the decision of every penny spent by a corporate. For a corporate, the time value of money is the cost of their capital (a topic that we can discuss in detail some other time). Now lets check how a corporate uses this concept in its decision making process with a simple example.
Should we upgrade the computer?
A large manufacturing firm is considering improving its computer facility. The firm currently has a computer that can be upgraded at a cost of Rs20000. The upgraded computer will be useful for 5 years and will provide cost savings of Rs7500 per year. The cost of capital (time value of money) is 15%.
Should the company spend Rs20000 in upgrading the computer?
If the company decides to upgrade, it will save Rs7500 every year for next five years. But the money has to be paid today, so the company must decide today whether it makes financial sense. So it needs to find what the saving is worth today - i.e. what is the sum of the present value of these savings in each year. Does that sound complicated? How it will do it? Just apply the above science of Discounting Cash Flow. Saving in year 1 (Rs. 7500) will be discounted by one year discounting factor, saving in year 2 by two years discounting factor and so on.
| Present Value of saving in year 1 | = 7500* 1/(1+0.15) | discount factor |
| | = Rs6522 | |
| Present Value of saving in year 2 | = 7500* 1/(1+0.15)2 | discount factor |
| | = Rs5671 | |
Similarly, you can calculate for third year as Rs4931, fourth year as Rs4288 and fifth year as Rs3728.
By adding the present value of all these savings you can get the present value of the total saving by computer upgradation in five years as Rs25140. The total cost of the proposed project is Rs20000. Hence the company can save a net of Rs5140 by undertaking the upgradation. This net value of saving is known as the Net Present Value (NPV).
So here is the conclusion from the example. If the NPV of the project is positive then go ahead with the project and vice versa. (and if companies go ahead with a project with a negative NPV - well, what can we say -that is throwing good money after bad!)
The story of project selection does not end here. When a corporate makes an investment decision, it may have an array of options or projects that they can undertake. As a simplistic example, if Reliance were to decide to spend Rs 200 Cr in increasing their polyester fibre capacity, they may compare it to acquiring an existing unit, or even with an altogether different project such as spending the money in the refinery or the jetty or a telecom project instead. . For all the options, the corporate will project the future cash flows and then calculate the net present value. One of the key tools in the selection of the project would be the one that yields the highest NPV.
But this is how companies take decisions. How you I use this NPV as an investor?
As an investor, you can use this discounted cash flow analysis for comparing the investment opportunities and selecting the better one. You decide your investment horizon, and calculate the possible cash flows from different investment options within that period of time. The option with the highest NPV represents the best investment worthy option.
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