Risk Of Management

Definition of 'Net Present Value - NPV'

The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.

NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield.

Formula:

In addition to the formula, net present value can often be calculated using tables, and spreadsheets such as Microsoft Excel.

Investopedia explains 'Net Present Value - NPV'

NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative.

For example, if a retail clothing business wants to purchase an existing store, it would first estimate the future cash flows that store would generate, and then discount those cash flows into one lump-sum present value amount, say $565,000. If the owner of the store was willing to sell his business for less than $565,000, the purchasing company would likely accept the offer as it presents a positive NPV investment. Conversely, if the owner would not sell for less than $565,000, the purchaser would not buy the store, as the investment would present a negative NPV at that time and would, therefore, reduce the overall value of the clothing company.

Definition of 'Random Walk Theory'

The theory that stock price changes have the same distribution and are independent of each other, so the past movement or trend of a stock price or market cannot be used to predict its future movement.

Investopedia explains 'Random Walk Theory'

In short, this is the idea that stocks take a random and unpredictable path. A follower of the random walk theory believes it's impossible to outperform the market without assuming additional risk. Critics of the theory, however, contend that stocks do maintain price trends over time - in other words, that it is possible to outperform the market by carefully selecting entry and exit points for equity investments.

This theory raised a lot of eyebrows in 1973 when author Burton Malkiel wrote "A Random Walk Down Wall Street", which remains on the top-seller list for finance books.

Although it is helpful to separate investment and financing decisions, there are basic similarities in the criteria for making them. The decisions to purchase a machine tool and to sell a bond each involve valuation of a risky asset. The fact that one asset is real and the other is financial doesn’t matter. In both cases we end up computing net present value.

The phrase net present value of borrowing may seem odd to you. But the following example should help to explain what we mean: As part of its policy of encouraging small business, the government offers to lend your firm $100,000 for 10 years at 3%. This means that the firm is liable for interest payments of $3,000 in each of the years 1 through 10 and that it is responsible for repaying the $100,000 in the final year. Should you accept this offer?

We can compute the NPV of the loan agreement in the usual way. The one difference is that the first cash flow is positive and the subsequent flows are negative:

NPV = amount borrowed - present value of interest payments- present value of loan repayment

= +100000 - ∑3000/(1+r)^t – 100000/(1+r)^10

The only missing variable is r, the opportunity cost of capital. You need that to value the liability created by the loan. We reason this way: The government’s loan to you is a financial asset: a piece of paper representing your promise to pay $3,000 per year plus the final repayment of $100,000. How much would that paper sell for if freely traded in the capital market? It would sell for the present value of those cash flows, discounted at r, the rate of return offered by other securities issued by your firm. All you have to do to determine r is to answer the question, What interest rate would my firm need to pay to borrow money directly from the capital markets rather than from the government? Suppose that this rate is 10%. Then

NPV= +100000-56,988=+43,012$

Of course, you don’t need any arithmetic to tell you that borrowing at 3% is a good deal when the fair rate is 10%. But the NPV calculations tell you just how much that opportunity is worth ($43,012). 1 It also brings out the essential similarity between investment and financing decisions.

COIN TOSS GAME

If you are not sure what we mean by “random walk,” you might like to think of the following example: You are given $100 to play a game. At the end of each week a coin is tossed. If it comes up heads, you win 3% of your investment; if it is tails, you lose 2.5%.

Therefore, your capital at the end of the first week is either $103.00 or $97.50. At the end of the second week the coin is tossed again. Now the possible outcomes are:

This process is a random walk with a positive drift of 25% per week. 3 It is a random walk because successive changes in value are independent. That is, the odds each week are the same, regardless of the value at the start of the week or of the pattern of heads and tails in the previous weeks.

Efficient markets

Economists define three levels of market efficiency, which are distinguished by the degree of information reflected in security prices. In the first level, prices reflect the information contained in the record of past prices. This is called weak market efficiency. If markets are efficient in the weak sense, then it is impossible to make consistently superior profits by studying past returns. Prices will follow a random walk.

The second level of efficiency requires that prices reflect not just past prices but all other public information, for example, from the Internet or the financial press. This is known as semi strong market efficiency. If markets are semi strong efficient, then prices will adjust immediately to public information such as the announcement of the last quarter’s earnings, a new issue of stock,

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