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Is Present Value – Value in the Present? The Economic sense behind Net Present Value

| Economics, Investing | Rating: 4.5
by Numan

Present value is a very common financial tool which is used to determine the current value of a future sum of money. 1,000$ a year from now, at 5% interest, are worth approx. 952$ (As you could deposit 952$ today, with 5% interest and receive 1,000$ in a year). Discounting is the process of translating future sums of money to present value.

Present value (or net present value in case of a series of timely cash flows) is also used to determine the economic feasibility of projects and entrepreneurships or in other words – Are they at all profitable? A project with a positive NPV is worth undertaking.

Net present value (or NPV) is widely used. However, seldom do we question the economic justification to use this financial tool and the economic source of an NPV. Does a positive net present value represent actual value in the present?

We should start at the very basic. What is the source of a positive NPV in a project? Where does it come from? For example, a construction company has decided to undertake a housing project in New York. Surely, the company has come to the conclusion this project has a positive NPV and as such is worth undertaking. Why is the discounted sum of cash flows positive?

The source of a positive NPV is a competitive advantage. This competitive advantage generates the positive sum of discounted cash flows for the company. Each competitive advantage is actually an economic market failure. Markets for labor, materials, technology and more are inefficient and entrepreneurs take advantage of this inefficiency.

This may sound extreme but is well demonstrated by the following example: Our construction company has gained hold over certain workers, contractors, land, instruments and more which enable it to undertake the housing project. The positive NPV is generated by the fact all those resources are unavailable to everyone.

Understanding where a positive NPV comes from is the first step. The more meaningful one is whether this positive NPV actually is value in the present? Can this competitive advantage be translated to value today?

When we come to think of it many firms generate value daily by a rise in stock prices. A company which has just received a new project, which is believed to be profitable, announces the news to the public to be rewarded, in return, with an increase in stock price. This is NPV at play. Believing the project would indeed be profitable the market assigns a higher value to the company today. This is transforming NPV to value in the present.

There are four distinct ways of transforming NPV to value in the present:

1. An IPO – A classic way of transforming NPV to value in the present. An IPO is selling a share in the entrepreneur’s initiative to potential investors. These investors understand or estimate a certain future profitability in the project and are willing to pay a certain sum today in order to benefit from future cash flows.

2. Selling the project – Selling the project as a whole to another company is another way of translating NPV to value in the present. Another company might be able to increase the project’s value even further due to some other market failure (such as scale advantages for example). This company would be willing to pay the entrepreneurs a certain sum of money today against a potentially higher NPV.

3. Selling the idea – Selling the idea is much the same as selling the project. Lacking the tools to actually make a project happen an entrepreneur might sell the idea to another company. Obviously, the other company has those tools, again, as a result of the aforementioned market failures. The value received by the entrepreneur today would of course be lower.

4. A loan – An entrepreneur can receive a loan based on future cash flow forecasts for his initiative. This loan is value received today against NPV.

A very important and overlooked conclusion should be noted here. Taking a second look at the way NPV is transformed to value in the present leads us to it. The conditions to transforming NPV to value in the present are:

1. An efficient financial market – In order to price company stocks and value information an efficient financial market is required. NPV can not be tuned into value in the present if an IPO can not be performed or valuated correctly.

2. Access to financial markets – With out access to an efficient financial market the entrepreneur, again, can not transform NPV to value in the present.

3. The existence of diversified investors – This condition is not intuitive. In order to correctly valuate a project using NPV a discount rate should be available. Discount rates are actually proxies for risk in a project. Diversified investors ignore specific risks and take into account systematic risks only. As a result the discount rate used by the diversified investors would be the lowest and as such would result in the highest value possible for the project. With out diversified investors a proper discount rate can not be agreed upon and the NPV can not be transformed to value in the present.

The further circumstances are from meeting these conditions more caution should be taken in utilizing NPV as a financial tool.

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