0:19

So what we have here is evidence from the US on a survey of Fortune 500 companies,

as well as from Australia in a similar survey of the very largest listed

companies on the Australian securities exchange.

Very simply, CFOs were asked what technique they always or

almost always use when evaluating new projects.

And what you'll see is that net present value analysis is the second ranked

of the project evaluation techniques.

So I guess you're wondering,

why not start with a discussion of internal rate of return?

Well, we get to internal rate of return in our next video.

But as you'll see, internal rate of return is simply an alternative way

most of the time of looking at net present value analysis.

So let's get into it.

1:08

Step 1 is to forecast the expected cash flows that we expect from the project.

That is, we need to know both the amount we expect the asset to produce or

the project to produce, the net amount.

So, inflows minus outflows,

as well as very importantly, the timing of that cash flow.

2:19

So we estimate that the initial cost of the machinery is $2 million.

The machinery will last for four years, and

you will expect that at the end of each of those years,

you'll generate net cash flows, cash inflows minus cash outflows of $800,000.

We also estimate that the appropriate discount rate is 10% per annum.

2:49

So here we have -$2 million as a negative cash flow at the start, and

then a series of four subsequent payments of $800,000, expected payments that is.

We employed discounted cash flow analysis to discount those future cash flows back

to their present value today.

Then, once we subtract the initial investment outlay, we end up with the NPV,

that is the net present value of the project, very simple.

3:18

The present value, of course, of $2 million dollars, that we need to spend

today, well, there's no time for the time value of money to have an effect.

Okay, so the present value of $2 million dollars received today

is equal to $2 million dollars.

$800,000 that we expect to occur at the end of the first year,

in present value terms equates to $727,723 today.

In two years' time, of course,

the $800,000 in present value terms, that second cash flow,

second net cash flow, in two years' time is worth less, $661,157.

The third cash flow, $601,052 and the cash flow,

the $800,000 net cash flow that we expect to occur in four

years' time translates to $546,411 today.

Let's just pause for a sec.

So intuitively what's going on here?

Let's consider that final cash flow.

As an investor, I'm indifferent between $546,411 in my hand immediately or

the promise of $800,000 in four years' time,

assuming the appropriate discount rate is 10% per annum.

Or if we switch that around a little bit, if you invest $546,411 today,

at 10% per annum for four years, it will accumulate to $800,000.

So the next step, the third step, is to add all those cash flows together,

because now they are recorded on a consistent,

more comparable basis that is in terms of their present value today.

So when we do this, we end up with an NPV of

$535,893, okay, a positive NPV.

What does that figure actually represent?

5:02

So the final step is to apply the appropriate decision rule.

And the decision rule varies depending upon whether we're talking about

independent projects or projects that are mutually exclusive.

When dealing with independent projects, the acceptance of one project doesn't

impact upon the acceptability of any other projects.

So, for example, imagine you're Kellogg's and there are two projects that land on

your desk or two proposals for projects that land on your desk.

Firstly, do we buy retail outlets in Japan?

And at the same time, another proposal is to upgrade underperforming factories.

5:36

Now that we've got four alternatives available to us,

we could accept both projects.

We could buy retail outlets in Japan, and

we could also upgrade our underperforming factories.

Our second alternative is to buy our retail outlets in Japan and

reject the underperforming factories if they don't meet our minimum benchmark.

6:08

So let's assume we are dealing with an independent project in this case.

The decision rule is very straightforward.

We accept all projects with a positive NPV.

We know this particular project has an NPV of $535,893.

That is the sum of the present values of the cash flows promised by

the project exceed the initial investment outlay by $535,893.

6:46

So the firm accepts the new project because it meets the minimum benchmark of

zero in net present value terms.

And it has a present value of net cash flows of $2,535,893, but

it's gotta pay $2 million for the project.

So the market value of the firm's assets increase by only $535,893.

The take away here is that the NPV reflects the incremental wealth

created by accepting a project.

So think about that.

If you pay $2 million for an asset that's worth only worth $2 million,

all you've done is converted cash into an asset.

And from an accounting perspective,

nothing's happened to the market value of the firm.

7:38

So what would happen if this was a project that wasn't independent but

was mutually exclusive to another project?

Let's define what we mean by mutually exclusive projects.

This occurs where acceptance of one project

necessarily leads to the rejection of the other.

The decision rule here is to accept the project with the highest positive NPV.

So for example, let's say we had an alternative to the Boxolator.

It's called the Packomatic.

And let's say that the Packomatic had an NPV of $409,070.

Well, because the NPV of the Boxolator exceeds the NPV of the Packomatic, and

is positive, we would always go with the Boxolator.

8:19

So that's the net present value technique.

The net present value technique is highly popular, and

we know that it's based upon discounted cash flow principles.

It results in a calculation of the net change in the value of the firm's assets

as a result of taking on the project.

There are four simple steps.

You forecast cash flows, timing in and out.

You discount those cash flows back to present values.

You aggregate them, you add them up.

You apply the appropriate decision rule.

And we understand that the decision rule changes slightly depending on whether

we're dealing with mutually exclusive or independent projects.