Assignment: Net Present Value and Other Investment
Criteria
As we have already established, the manager's main aim is to maximise shareholder wealth. In order to maximise shareholder wealth, managers must choose investments that will increase the return to their shareholders and the value of the firm. Investments must be chosen that will provide value to the owners.
There are numerous measures that allow a firm to establish the viability of a project. These measures include the payback period-which is considered the most simplistic measure; however, it does not take into account the discount value of future cash flows-the discounted payback period, the accounting rate of return, the NPV and the IRR. While all these methods have advantages and disadvantages, the NPV and the IRR are among the most accurate and provide the most relevant information.
Shareholder wealth or value can be created by choosing investments that have a positive NPV that is, the value of the investment in today's dollars outweighs the costs of the investment also calculated in today's dollars. For an investment decision to be considered viable, the NPV value must be positive, because only when the NPV value is positive will the desired investment add any value to the firm. The NPV can be described as the measure of how much value is created or added by undertaking this particular investment.
The IRR is a measure that is linked quite closely with the NPV, and it is also considered a desirable measure in relation to the viability of an investment decision. The IRR can be described as the discount rate that makes the NPV of an investment zero. When using the IRR method as a choice for investment decisions, we may only select the investments that produce an IRR figure that is higher than our required return.
The article 'Discounted cash flow and other valuation tools' appeared in the Sydney Morning Herald' on 27 September 2003 and demonstrates the value of discounted cash flows and their use in predicting which stocks will appreciate in the future. This method of discounted cash flows allows fund managers to predict the direction of future stocks, by predicting what their value should be by looking to their future cash flows, discounted for today. This in turn should provide intrinsic value to the fund shareholders.
Considering the above information and the Sydney Morning Herald article, complete the following five questions. Note: Ignore taxation in all questions.
I See article 'Discounted cash flow and other valuation tools'.
Question 1
List the methods that a firm can use to evaluate a potential investment.
Question 2
Why is the NPV a preferred method when evaluating a potential investment opportunity?
Question 3
What is the IRR? How is it related to the NPV? Is the IRR always an effective method when evaluating a potential investment opportunity, and why?
Question 4
Using the article from the Sydney Morning Herald, discuss why John Whiteman, the senior portfolio manager at AMP Henderson, can be considered 'skilled' in respect of his stock pickings. Why would it benefit fund managers to use discounted cash flows when picking stocks?
Question 5
A firm that pays out 65% of its earnings as dividends has an accounting rate of return of 20%. Its P/E ratio is 10 and its earnings per share is 108 cents.
What is the price per share?
What is the dividend yield?
If shares were bought, what would be the payback period? Assume the only return is the dividend.
What is the net book value per share of the asset investment of the company? If the risk-adjusted required rate of return is 6%, what would be the NPV per share for buying shares?
Would you buy shares using AROR or NPV?
Discounted cash flow and other valuation tools
Author: Simon Hoyle
Words: 605
Publication: Sydney Morning Herald Section: Business
Page: 49
Source: SMH
The ingredients that make a successful stock-picking technique have not changed much over the years. They are a mixture of a careful analysis of quantitative factors (such as debt levels, the effect of capital raisings and other financial data), and qualitative factors (such as the perceived ability of a company's management to execute its strategy, the likely impact of competition on a company's products or services, and so on).
It's not always easy to learn from managers how to pick stocks; sometimes they won't always talk about it. Colonial First State, for example, declined to talk to the Herald for this article.
But John Whiteman, a senior portfolio manager for AMP Henderson, says his firm uses a technique designed to calculate an intrinsic value for a stock that uses forecasts that go out 10 years.
In July, Whiteman and his team at AMP Henderson were named by Monitor Money (and reported by the Herald) as being among a handful that could be classified as "skilled". This means there is a high level of confidence that Whiteman's performance occurs because he knows what he's doing.
"We use, as our main tool, discounted cash flow (DCF)," Whiteman says. "We forecast out at least 10 years. You have to admit that in doing that you're going to get less accurate as you go out, because you are looking more deeply into your crystal ball.
"At its simplest, DCF is just plotting out from year to year what the excess cash flow from operating that business will be.
"Once you've plotted out what the cash flow from the business is going to be you discount it back into today's dollar terms. You're trying to work out what today's share price should be, given the future cash flows of the business.
"Despite some of its complexities, it's a really useful tool.
"But what you are not going to get out of a DCF is something that says a stock is worth $5.56 and the share price [today] is tracking at $5.50 so therefore it's a buy for that 6c. But every now and then you stumble across something that's trading at a 20 per cent plus discount to what you think it's worth. That's where the real opportunities are."
Whiteman says there are also qualitative factors that come into play, such as analysing the industry that a company is in, or the ability of the company's management to hit its growth targets.
"These filters are designed to sort out which stocks are cheap because other investors have overlooked them, and which are cheap because they really are duds.
"More often than not, we'll do a quick overview DCF for a company and if we find things that we think represent opportunities, we go out and make phone calls, visit the company and make sure the assessments we're making are in line with what management is saying.
"But just taking management's forecasts isn't good enough because even though they look at their business at a microscopic level, that doesn't mean they will always be right.
"It's a reality check, at the end of the day."
Already, the question of style is not easy for AMP to answer.
" We don't like being put into a box, because we haven't set out to be either value or growth," Whiteman says.
"However, our fund's performance has a higher correlation to growth managers than it does to a value managers, so when forced, that is how we are generally categorised."
FORMAT REQUIREMENT:
The group paper should
• Be typed and double spaced;
• Flow as a well documented coherent, committee paper;
• Cite all sources;
• Have correct formats for the bibliography, footnotes and reference;
• Have on the first page of the paper, the title of the paper, the authors' names and respective tutorial groups; and
• Have an executive summary.
Quality is the most appropriate determinant of the grade awarded but it is suggested that approximately 700-1000 words is a suitable length.
SPECIFIC REQUIREMNETS:
Answer ALL the questions at the end of the case and then qualitatively summarize the results of the computations. What insights do the computations provide for capital budgeting evaluations and project analyses?