Net Present Value Method – Discounting Foreign Cash Flows
NPV tells you: "How much wealth will this project create for shareholders in today's money?".
1. The Logic
₹100 next year is worth only ₹90 today (at 10% interest). We must "Discount" all future cash flows to today's value and compare with Investment.
- Formula:
NPV = PV of Inflows - Initial Investment. - Rule: Accept if NPV > 0.
2. Estimating Discount Rate (k) for MNCs
For foreign projects, the discount rate (k) is adjusted:
k = Risk Free Rate + Beta(Risk Premium) + Country Risk Premium
- Country Risk: If Vietnam is risky, add 2-3% to the discount rate. Higher rate = Lower NPV.
3. Diagram: The Decision Process
1. Forecast"Cash Flows in years 1 to 5."
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2. Discount"Convert future flows to Present Value using Cost of Capital."
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3. Sum"Total PV of Inflows."
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4. Subtract"Total PV - Initial Investment = NPV."
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5. Decide"Positive? Accept. Negative? Reject."
4. Exam Notes: Writing the Answer
Question: "Why is NPV considered the best method?" (5 Marks)
Answering Strategy:
- TVM: It considers Time Value of Money.
- Wealth: It measures absolute increase in shareholder wealth.
- Risk: It allows adjusting for risk by changing the discount rate.
Summary
- King of Methods: In any conflict (e.g., NPV says Yes, IRR says No), always follow NPV.
- Positive NPV: Means the project earns more than the cost of capital.
Quiz Time! 🎯
Test Your Knowledge
Question 1 of 4
1. NPV represents: