CAT / FIA FFM Syllabus E. Investment Decisions - NPV - Notes ^{5 / 9}

This method is examined regularly

What it does is looks at all the projected future CASH inflows and outflows.

Obviously we hope the inflows are more than the outflows. If they are this is called a positive NPV

However, it also introduces the concept of the “time value” of money.

The idea that money coming in today is worth more than the same amount of money coming in in 5 years time. To do this we “discount down” all future cash flows.

This “discounting” takes into account not only the time value of money but also the required return of our share and debt holders.

This means that if we have a positive NPV (even after discounting the future cash flows) then the return beats not only the time value of money but it also beats what the shareholders and debt holders require.

So they will be happy and the company value (and hence share price) will rise by the +NPV amount (divided by the number of shares)

So, let’s look at how we calculate NPVs in an exam..

NPV Proforma