Valuation has been one of the most challenging areas in applied and theoritical finance. Available tools for valuation can broadly be classified based on the nature of inputs required for performing the exercise: it may be accounting information based or cash flow based measures. One of the most important accounting information based investment appraisal or valuation tool is the Accounting Rate of Return-computed as a ratio of average net income to average investments. Apart from being influenced by creative accounting, this measure also does not consider time value of money implying that in this appraisal model Rs 100 today is equally worthy irrespective of whether it is realized today or ten years later!
Cash flow based measures typically refers to payback period, internal rate of return, and net present value rule. The payback period, as the name would suggest, evaluate a project in terms of the number of years a project would take to recover the initial investment/outlay involved. This method can be made more realistic and usable by incorporating present value of cash flows rather than cash flows alone, in which case its name is modified to discounted pay back period. The accept/reject criterion is based on the cut-off period decided by management: if the cut-off period is higher than the (discounted) pay back period, the project is accepted; or else the project is rejected. Inspite of its intuitive appeal and its capacity to adress issues associated with firm liquidity, this evaluation tool is rarely used alone primarily because of the fact that it ignores all cash flows post the pay back period.
Tthis leaves us with internal rate of return and net present value rule. Internal rate of return (yield equivalent in the context of a bond/debenture) is the discounting factor that equates the cash inflows with the cash outflow associated with the project. The accept/reject criterion is simple in terms of comprehension: if the yield of the project exceeds the required return for capital providers (in terms of the weighted average of cost of debt and expected retuen for equity shareholders, the weights being their respective share in the capital structure) accept the project; or else reject. While prima facie this technique addresses all limitations of other evaluation techniques, it is itself not free from limitations of a different dimension. Notably, IRR cannot distinguish between borrowing and lending type projects, it fails to provide an answer in case there are multiple cash outflows involved (Modified IRR comes to the rescue), it implicitly assumes that all cash flows are reinvested at the IRR which may not be a tenable proposition, and there may not be an IRR for certain cash flow patters at all! Added to these the internal rate of return as a monolithic whole becomes uncomparable with expected return when the term structure of interest rates is upward sloping and a single IRR for a project with, say, a life of 30 years is also untenable because risk and expected return changes along with the life stage of the project. This leaves us with the lone survivor, the net present value (NPV) rule.
NPV as the name suggests computes value or wealth addition on the net, it computes present value of cash inflows and compares it with outlays. if the former exceeds the later the project is accepted, or else it is not. The discounting factor used in this case is the weighted average cost of capital. The NPV rule addresses all the limitations of the IRR rule and incorporates the corporate objective of shareholders wealth maximization in decision making. Apparently, with the NPV rule one felt secured, for we often thought that investment appraisal and valuation would be more objective than ever before. Appraiser aslo noted that this tool can be modified to do a sensitivity (changing one input at a time) analysis or a scenario (changing multiple factors in one go) analysis to incorporate complex ‘what if’ factors that might happen and impinge on the quality of the project.
Off late however a realization has dawned that even NPV is not the be all and end all of investment appraisal. consequently one needs to look at what ails NPV rule.
Let us ponder for a moment and raise a few questions. These questions it is felt will go a long way in adressing the probles of NPV. Are capital invest decisions, obligations? Or are they options that a company hold? Are they a ‘now’ or ‘never’ proposition? Cant investments be postponed? Does a negative NPV project not turn green when prices vary? How do we value companies based on stem cell research or other high technology ventures whose cash flows are very very uncertain?
We would deal with these and many more in part II of this series.