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npv analysis NPV ANALYSIS AND APPLICATIONS FOR COMPETITIVE INTELLIGENCE DEREK JOHNSON, Aurora WDC Within the broad category of Conversely, if the NPV is negative, If your competitors are public finance, there are many tools and taking on the investment dilutes the companies, this information is in their techniques available for use by firm’s value and should be rejected. But public financial statements. If your competitive intelligence (CI) first, let’s discuss how to arrive at competitors are private companies, (as professionals to analyze the general appropriate discount rates and calculate is often the case), finding these figures financial health of a company and its a firm’s Weighted Average Cost of often requires primary research. competitors. Whether your firm or your Capital (WACC). Suppose your firm has a market client might be considering such things value of $1 billion and is currently as mergers & acquisitions (M&A) operating at its target debt/equity ratio analysis or project valuation, net present WHAT IS THE APPROPRIATE of 33.3%. These values indicate total value (NPV) analysis is a very simple DISCOUNT RATE? debt of $250 million and total equity of tool that can be used with great The choice of discount rate to use $750 million. Continuing further, benefits. in your NPV analysis can have serious suppose that the firm’s cost of debt is impact on results and there are several 12% and the required return to equity different ways to arrive at an shareholders, which can be calculated in WHAT IS NPV ANALYSIS? appropriate discount rate. As a general several different ways, is 15%. Finally, The net present value of an rule, you should use a discount rate that the firm has a corporate tax rate of investment is: matches the way in which your firm is 34%. The WACC returned to us in this • the value an investment must financed. calculation is 13.23%. (See Table 1.) represent today If a firm were entirely financed • on a discounted cash-flow basis with equity, the most appropriate • to make an investment worthwhile discount rate to use would be the HOW IS NPV CALCULATED? after taking into account the cost of required return to equity required by The NPV is the sum of the the investment shareholders. A more realistic notion is discounted future cash flows less the that the firm in question is financed cost of undertaking the project. For Discounted cash flow numbers are with some allocation of debt and equity, example, if Firm A wants to acquire arrived at by estimating the cash flows in which case using the firm’s WACC is Firm B for $50 million and expects in your future scenario, and adjusting most appropriate. Firm B to produce cash flows of them to a value they represent today 15,000,000, 20,000,000, and based on some predefined discount rate. 27,500,000 at the end of each of the The NPV is the sum of the discounted WEIGHTED AVERAGE COST OF next three years, the NPV of the cash flows minus the cost of the CAPITAL investment in Firm B would be investment. If the NPV is positive, the You can calculate the WACC if you $826,447 (using a discount rate of investment is worth taking on because have the firm’s equity and debt market 10%). (See Table 2.) it is essentially the same as receiving a values, the cost of equity, the cost of To discount the future cash flows, cash payment equal to the NPV. debt, and the firm’s corporate tax rate. simply take the expected cash flow divided by [(1+discount rate)^time TABLE 1: WEIGHTED AVERAGE COST OF CAPITAL period]. For example, in period 3, the $27.5 million cash flow is discounted Mkt. Value Cost of Capital by taking 27,500,000/[(1+10%)^3]. Financing (millions) Weight (After tax deductibility on bonds) WACC Debt $ 250 25.0% 12% x (1-0.34) 1.98% NPV IN AN M&A SCENARIO Equity 750 75.0% 15% 11.25% The use of NPV analysis is $ 1,000 100.0% 13.23% probably most straightforward in an M&A scenario due to the difficulty 48 Competitive Intelligence Magazine npv analysis TABLE 2: NET PRESENT VALUE they upgrade the existing machine, the new machine’s $2.0 million cost results Cash Inflows 15,000,000 20,000,000 27,500,000 in the negative NPV as shown. In this Year 0 1 2 3 scenario, it is clear that the firm should Cash Outflows (50,000,000) upgrade the existing machine, adding Discount Cash Flows (50,000,000) 13,636,364 16,528,926 20,661,157 value to the tune of $43,809 within the firm. (See Table 3). Net Present Value (NPV): 826,447 Discount Rate (I): 10.0% CI APPLICATIONS inherent in projecting cash flows in a Consider an example within a Now that you have the background project scenario. Within M&A, you manufacturing environment where a of how NPV is calculated and a few need only know the value of both the firm must either upgrade a machine or examples of using this tool, how do we acquirer and firm being acquired, along purchase a new machine to satisfy apply it within a CI function? We know with any synergies expected from the expected production needs for a new that if given the right information merger. product. Table 3 indicates the firm’s about an M&A or project scenario, As a brief example, consider market alternatives, including the expected calculating the NPV and analyzing this values of Firm A and B of $400 million flows (note that I am using the 13.23% information is relatively straight- and $200 million, respectively (both WACC calculated above as the discount forward. CI professionals without a firms are financed entirely with equity). rate). strong financial background can use this The market believes the combined firm The firm anticipates they will information to arrive at probabilities of will have a market value of $750 experience cost reductions of 100,000 certain projects and company initiatives million post-merger, indicating in each of the next three years if they being sought. synergies between the two firms of upgrade, versus annual cost reductions Knowing the cost of a project and $150 million. Firm B’s board of of 125,000 if they purchase the new the estimated cash flows, along with the directors will merge with Firm A only if machine. While the new machine firm’s financial information described given $275 million in cash, or a $75 allows the firm to book greater annual above, the CI department can attempt million premium to its current market revenues in the coming years than if to predict which acquisitions or value. The NPV of this scenario to Firm A’s shareholders is $75 million ($750- 400-275). TABLE 3: NPV IN A PROJECT VALUATIONS SCENARIO In this example, the value placed Option A: Upgrade Existing Machine on the synergies between the two firms is critical. Synergies generally present Year 01 23 themselves through revenue Cost: (1,000,000) enhancement, cost reduction, lower Expected Flows - Revenue Increase 275,000 350,000 425,000 taxes, and a lower cost of capital within Expected Flows - Cost Reduction 100,000 100,000 100,000 the combined firm. The synergy value is Total Expected Cash Flows (1,000,000) 375,000 450,000 525,000 the sum of the discounted cash flows, expected in the predictable future, Discounted Flows (1,000,000) 331,184 350,986 361,639 resulting from these activities. NPV 43,809 Option B: Purchase New Machine NPV IN A PROJECT VALUATION SCENARIO Time Period 0 1 2 3 When firms commit to a project, Cost: (2,000,000) they often have several project options Expected Flows - Revenue Increase 500,000 625,000 750,000 available to them. Some of these Expected Flows - Cost Reduction 125,000 125,000 125,000 projects are alternatives to each other, After-tax Salvage Value - Old Mach. 132,000 while others are mutually exclusive. Total Expected Cash Flows (1,868,000) 625,000 750,000 875,000 NPV analysis can be used to determine which project(s) to invest in given a set Discounted Flows (1,868,000) 551,974 584,976 602,731 CAPEX (capital expenditures) budget. NPV (128,319) Volume 6 • Number 3 • May-June 2003 49 npv analysis investments their competition will than others, as is the case with all M&A and Project Valuation as my engage in near-term. Using the CI business and financial metrics. I examples, NPV analysis can also play function’s resources to obtain the strongly believe that the use of this tool, valuable roles within lease-or-buy information, coupled with the decision combined with other financial tools decisions, capital budgeting, and stock rules used within NPV analysis, will such as financial statement analysis, can or bond investment alternatives. allow a company to make important quickly indicate whether further due strategic and tactical decisions with diligence into a specific M&A or their investment dollars. project valuation scenario, for example, When engaging in financial is worth your time. Derek Johnson is a chartered financial competitive intelligence, there are many I recommend incorporating NPV analyst and executive director of the tools CI professionals can use to add analysis into your early qualifying Recon Intelligence Outsourcing Bureau value to their processes. NPV analysis is criterion within most financial at Aurora WDC. Email him at more appropriate in some situations measurement scenarios. While I used [email protected].
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