Npv Analysis

48 Competitive Intelligence Magazine

Within the broad category of

finance, there are many tools and

techniques available for use by

competitive intelligence (CI)

professionals to analyze the general

financial health of a company and its

competitors. Whether your firm or your

client might be considering such things

as mergers & acquisitions (M&A)

analysis or project valuation, net present

value (NPV) analysis is a very simple

tool that can be used with great

benefits.

WHAT IS NPV ANALYSIS?

The net present value of an

investment is:

* the value an investment must

represent today

* on a discounted cash-flow basis

* to make an investment worthwhile

after taking into account the cost of

the investment

Discounted cash flow numbers are

arrived at by estimating the cash flows

in your future scenario, and adjusting

them to a value they represent today

based on some predefined discount rate.

The NPV is the sum of the discounted

cash flows minus the cost of the

investment. If the NPV is positive, the

investment is worth taking on because

it is essentially the same as receiving a

cash payment equal to the NPV.

NPV ANALYSIS AND APPLICATIONS FOR

COMPETITIVE INTELLIGENCE

DEREK JOHNSON, Aurora WDC

Conversely, if the NPV is negative,

taking on the investment dilutes the

firm's value and should be rejected. But

first, let's discuss how to arrive at

appropriate discount rates and calculate

a firm's Weighted Average Cost of

Capital (WACC).

WHAT IS THE APPROPRIATE

DISCOUNT RATE?

The choice of discount rate to use

in your NPV analysis can have serious

impact on results and there are several

different ways to arrive at an

appropriate discount rate. As a general

rule, you should use a discount rate that

matches the way in which your firm is

financed.

If a firm were entirely financed

with equity, the most appropriate

discount rate to use would be the

required return to equity required by

shareholders. A more realistic notion is

that the firm in question is financed

with some allocation of debt and equity,

in which case using the firm's WACC is

most appropriate.

WEIGHTED AVERAGE COST OF

CAPITAL

You can calculate the WACC if you

have the firm's equity and debt market

values, the cost of equity, the cost of

debt, and the firm's corporate tax rate.

If your competitors are public

companies, this information is in their

public financial statements. If your

competitors are private companies, (as

is often the case), finding these figures

often requires primary research.

Suppose your firm has a market

value of $1 billion and is currently

operating at its target debt/equity ratio

of 33.3%. These values indicate total

debt of $250 million and total equity of

$750 million. Continuing further,

suppose that the firm's cost of debt is

12% and the required return to equity

shareholders, which can be calculated in

several different ways, is 15%. Finally,

the firm has a corporate tax rate of

34%. The WACC returned to us in this

calculation is 13.23%. (See Table 1.)

HOW IS NPV CALCULATED?

The NPV is the sum of the

discounted future cash flows less the

cost of undertaking the project. For

example, if Firm A wants to acquire

Firm B for $50 million and expects

Firm B to produce cash flows of

15,000,000, 20,000,000, and

27,500,000 at the end of each of the

next three years, the NPV of the

investment