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3.5. Using NPV – what should we know

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Principles of Corporate Finance – A Tale of Value

Moscow Institute of Physics and Technology

5 (6 ratings) | 1.5K Students Enrolled

Course 2 of 5 in the Understanding Modern Finance Specialization

The study of Corporate Finance seems to be a very generic part of business education. Still, it either falls in the trap of intimidating formulas or is superficially journalistic. Both extremes preclude the understanding of the core finance ideas, concepts, and models. This Course is an attempt to avoid the above extremes. We discuss the core basis and mechanisms of modern corporate finance in a learner-friendly way. We will analyze the market’s most fundamental problems, realize the intrinsic interests and preferences of investors, reveal the true meaning of specific financial terms, and uncover important issues that are so often ignored in choosing and valuing investment projects. The learners will gain insight into the essence of corporate finance. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses.

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5 (6 ratings)

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From the lesson

Making the Choice of Good Investment Projects. NPV and Other Criteria. Why Is NPV Better?

We start Week 3 of the Course by the discussion of criteria of choosing investment projects. Beside NPV, the internal rate of return (IRR) and other approaches are introduced. We show why the NPV criterion is the best and why the application of others may lead to wrong investment decisions. Then we focus on the main ideas to be taken into account while setting up cash flow patterns and making the choice of project on the basis of NPV. We mention some special issues – relevant costs, depreciation, inflation. We present the concept of equivalent annual cost (EAC) as a method of comparing projects of different length. Then we study the application of EAC in greater detail in a case.

3.1. Why use NPV as a criterion of the choice of projects?5:53

3.2. Other criteria – pluses and minuses8:26

3.3. Internal rate of return (IRR)8:28

3.4. Problems with IRR – it’s not exactly like NPV!12:52

3.5. Using NPV – what should we know3:58

3.6. NPV and cash flows. Some accounting details11:39

3.7. Sunk costs – opportunity costs – relevant costs10:55

3.8. Depreciation – an overview relevant to cash flows5:51

3.9. Discount rates – nominal and real. The role of inflation6:02

3.10. Projects of different length. Equivalent annual cost (EAC)9:32

3.11. EAC – an example11:58

3.12. Conclusions and unanswered questions10:15

Taught By

Konstantin Kontor
Director and Professor of Finance and Strategy

Transcript

Well, in this short, wrap-up episode, we will put together all the things that we have so far discussed with respect to why NPV is better. We basically said that the approach of NPV serves the goal of value maximization. Because it is better in terms of representations of the interests of major stakeholders that worry about value. Because remember when we talked about dealing with accounting. We said that in accounting most stakeholders are outsiders or managers. And oftentimes they put some more emphasis on net income and other accounting criteria. And it is the NPV criterion that actually puts more emphasis on the idea of cash flow, which is key in value creation. So that is the overall view. Now, we studied a couple of other criteria. And then we basically said that some of them are poor, some of them are better, some of them are close to NPV. Some of them are actually similar, given certain simplifying assumptions. But for now, we are moving towards applying, NPV, let's say we all agree that this is better. Now, what should we do in order to apply that in real-life situations? You remember that NPV is all about cash flows and r's. So in our second week when we studied some examples, we were taking these cash flows and r's as givens. Now, reality is, unfortunately, not so simple. So you have to somehow extract these cash flows and r's. Now, in what follows this week, we will mostly discuss the correct treatment of these cash flows. So basically our job is, I put that in red, we have to avoid mistakes here. So we are not pretending to know that for sure or with certainty, but our job is not to commit mistakes. So let's see, we have here, Cash flows, and then here we have r's. So about r's, this is, like I said, mostly week 4, mostly. But some observations we will do right now. But with cash flows, this is what we will study in the following episodes. And our job is basically what to discount, how to discount, and what must be taken into account in order to avoid making mistakes. So this is not so trivial, because oftentimes people are tempted to read cash flows in a simplified way. And sometimes it's a good approximation. But sometimes that results in potentially really gross mistakes that cannot be any longer disregarded. And that's exactly what we will do. So basically these major questions, like what to discount, and why this and not that. This is what we will study, starting from the next episode.

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