“NPVs theoretically raise the value of the company and the value of the stock” isnt the value of the stock and company the same thing if the stock is accurately priced??
don’t forget the value of debt
is this a statement in the CFAI materials or an article that you read?
I think I saw in a corp finance text that the value of a firm is the value of its assets, or the sum of debt and equity. Actually I’m not sure what “NPVs” is. I took it to mean “positive-NPV projects”. It’s possible for a new project to have opposite effects on equity and total enterprise value, if you view equity as an option struck at the value of debt. The option’s value increases with volatility. A highly volatile but negative-NPV project (i.e., with very uncertain cash flows, either positive or negative) could increase the value of stock while decreasing expected TEV. (If the project turns out to be a stinker, not only could equity fall to 0, but the value of debt could tank too.) A postive NPV project will generally increase both equity and TEV. Not sure if that’s what bmw was asking though.
I agree with DH’s view wrt volatility; it’s a key element missing in NPV. In fact isn’t firm beta simply an average of all the project betas? In turn the beta dermines a firm’s value. Not sure about the option model or the distinction between equity and debt though (they should be taken care of in the NPV discount rate and will manifest in return volatility). I think the problem with the statement is the key word “theoretically”. NPV is hugely dependent on the input assumptions. I don’t think any firm undertakes a project knowing that it will lose money (negative NPV); they find out when the project tanks. I think that the key is to do a thorough sensitivity analysis prior to starting a project; it would help to weed out unprofitable profits; it should add that element of risk analysis that’s missing.
> Not sure about the option model or the distinction between equity and debt though http://www.investopedia.com/terms/m/mertonmodel.asp > I don’t think any firm undertakes a project knowing that it will lose money (negative NPV); You’re a manager whose compensation is dominated by 10,000 call options that are struck at the current stock price. Given two projects: A. Cash flows are either +50 or -100 B. Cash flows are always +1 which do you choose? (This is why you never compensate managers with options; their incentives won’t align with those of share- or debt-holders.) See e.g. http://en.wikipedia.org/wiki/Agency_cost
DarienHacker Wrote: ------------------------------------------------------- > I think I saw in a corp finance text that the > value of a firm is the value of its assets, or the > sum of debt and equity. > Be nice…
Prabulous Wrote: ------------------------------------------------------- > > I don’t think any firm undertakes a project > knowing that it will lose money (negative NPV); Of course, there is no uncertainty in that statement so the option models don’t apply. Anyway, there can be all kinds of reasons for companies to take on negative npv projects. Charitable projects, public image enhancement, employee morale, tax benefits, timing issues (hey, I’ll be retired when the s%^t hits the fan), etc…
Equity value (derived from the NPV of cashflows which also includes a terminal value if the company if it is a going concern) + Debt + Cash = Enterprise value
kui, be careful only to include “surplus” cash, that beyond what’s needed to fund WC requirements. (In general you would add any nonproducing assets, whether they be surplus cash, undeveloped land, artwork, anything that doesn’t contribute to generating revenue for the firm.)
JoeyDVivre Wrote: ------------------------------------------------------- > DarienHacker Wrote: > -------------------------------------------------- > ----- > > I think I saw in a corp finance text that the > > value of a firm is the value of its assets, or > the > > sum of debt and equity. > > > Be nice… Honestly! I couldn’t remember whether I first saw that in a CF or accounting book. Or maybe it was in Investments.
kui, EV = Equity value + Debt value + Cash - this is incorrect. EV = Equity value + Debt value - Cash - the value of cash is already incorporated in the value of equity But if you mean equity value as only NPV of firm’s investments then you’re right.
cfa_moscow Wrote: ------------------------------------------------------- > kui, > > EV = Equity value + Debt value + Cash - this > is incorrect. > EV = Equity value + Debt value - Cash - the > value of cash is already incorporated in the value > of equity > > But if you mean equity value as only NPV of firm’s > investments then you’re right. Nearly completely wrong. [Note that we may be getting into topics beyond CFA’s curriculum; still I feel compelled to correct the record.] Assuming your company is subject to a cash cycle (and only Dell isn’t, or wasn’t at one time)* then you must have cash as part of your working capital. Analysts will typically have an industry-specific rule of thumb for cach requirement for a firm of a given credit rating. E.g., say an IG firm in retail needs 5% of sales in cash (where that cash fluctuates down and up during the normal cycles of operation). That cash is essential to generating revenues, just as SG&A and COGS and inventories and A/R are, so it’s already baked into the “equity” value (which kui defines as DCF). If you try to run that same firm without the 5% cash it will quickly grind to a halt, just as if you tried to run it without other fixed or soft assets. So say we look at a retail firm and notice that in addition to warehouses and inventory and sales outlets and trucks and price tags they have 1m acres of Alaskan wilderness, and 7% of revenue in cash. The Alaskan wilderness isn’t required for generating the cash flows, neither is the extra 2% cash. So on top of the DCF equity you must add these nonproducing assets to arrive at the price you’d have to pay for this firm (which is essentially 3 entities: retail sales firm, Alaskan wilderness, a bit of cash). * and presumably no customer of Chuck Norris would be fool enough to try to buy on credit – Chuck’s days on receivable is always 0 Sorry, I’m too lazy to look up a reference to this, you’ll just have to trust your common sense. Plus as the first poster in the thread to mention CN I believe I’m declared the victor.
DarienHacker, Of course I meant excessive cash. Generally I was talking about all non-revenue-generating assets.
“NPVs theoretically raise the value of the company and the value of the stock” This is theoretically true, unless investors have already appropriately assessed the value of the stock and thus the firm’s cost of capital and thus the stock price based on expected cash flows from NPV’s. But, the statement is much more complex. First, NPV is the “Net Present Value” of all cash flows of a project (I can provide an accounting method to calculate this if requested). The PV calculation for all future cash flows of the project uses the company’s weighted average cost of capital (WACC) as the discount rate. There are caveats to this (for example, if the firm is starting a new project that is unrelated to the main operations of the business, then the firm should use a discount rate relevant to that other industry rather than it’s own WACC). If a company invests in a project that has an NPV of zero, then it simply has earned its WACC, and the added value is zero. If NPV is positive, then the company has not only covered its cost to finance the project (its cost of capital) but has increased the value of the firm. The residual value goes to net income and thus to retained earnings. Therefore this residual value goes directly to common shareholder’s equity and by-passes debtors (bond holders and preferred shareholders). Second, WACC is based on current market value (not the company’s book value) of Bonds, Preferred Shares and Common Shares (relative weights of B, PS, CS are its capital structure). Current market values are determined using the market costs of capital for debt, preferred shares and common shares. This is important in evaluating the expected net cash flows from NPV’s and determining whether there will be a positive NPV or not. Last, (regarding Joey’s comments about negative NPV’s) from a purely financial management perspective, firms should invest only in projects that increase shareholder’s wealth. So, if there is a project with negative NPV, then this should be rejected. If the management continues with this project for other reasons, then I am not sure how or if this project should be included in calculating the firms WACC.
JoeyDVivre Wrote: ------------------------------------------------------- > Anyway, there can be all kinds of reasons for > companies to take on negative npv projects. > Charitable projects, public image enhancement, > employee morale, tax benefits, timing issues (hey, > I’ll be retired when the s%^t hits the fan), etc… I’d argue these are all +NPV. Companies contribute to charity either because the owners value that (and can put a $$ value on that warm fuzzy feeling) or because they think their customers will reward them. Employee morale improvement is expected to reduce COGS or SG&A. Etc. The only way to compare apples and oranges like these is to reduce everything to a common coin. We could convert everything to pats-on-the-back, but it’s probably easier to convert it all to say USD, even if some of the conversions are subjective, drive you into dustier corners of utility theory, and so on. But to reiterate my earlier point about agency costs: managers are often in the position to take on projects that are +NPV *for the manager* but are -NPV for the firm. E.g. hiring their spouse at $1m/yr to empty wastebaskets.
maybe i’m completely off here, but i think bmwhype is asking why they made a point of stating both the value of the company and the value of the stock… when they should be highly coorelated (increase in company value should mean that there was an increase in stock price as well). since its bmw’s question, i should let him explain, but that was my take.
bird, see the discussion starting September 13, 2007 03:47PM about examples where a project accpetance could increase stock value while reducing company value. Not the most common behavior of management, but it certainly happens. If we widen the scope of the consideration (to mgmt actions beyond deciding whether to take on projects, be them +ve or -ve NPV), then a simple levered recap (issue debt to repurchase shares) might increase value of stock while reducing firm value by transferring value from bondholders to shareholders and increasing overall firm risk. (This fueled a lot of 1980s MBOs in fact before bondholders wised up.) So a mgmt action that increases equity value doesn’t necessarily increase firm value. Usually, yes, but necessarily, no.
DarienHacker Wrote: ------------------------------------------------------- > JoeyDVivre Wrote: > -------------------------------------------------- > ----- > > Anyway, there can be all kinds of reasons for > > companies to take on negative npv projects. > > Charitable projects, public image enhancement, > > employee morale, tax benefits, timing issues > (hey, > > I’ll be retired when the s%^t hits the fan), > etc… > > I’d argue these are all +NPV. Companies > contribute to charity either because the owners > value that (and can put a $$ value on that warm > fuzzy feeling) or because they think their > customers will reward them. Employee morale > improvement is expected to reduce COGS or SG&A. > Etc. > > The only way to compare apples and oranges like > these is to reduce everything to a common coin. > We could convert everything to pats-on-the-back, > but it’s probably easier to convert it all to say > USD, even if some of the conversions are > subjective, drive you into dustier corners of > utility theory, and so on. > > But to reiterate my earlier point about agency > costs: managers are often in the position to take > on projects that are +NPV *for the manager* but > are -NPV for the firm. E.g. hiring their spouse > at $1m/yr to empty wastebaskets. Of course that’s the usual argument for those kinds of projects - that in the long run, giving to charity, e.g., enhances shareholder value by some cosmic kharma balance or something. IMHO, that’s taking the whole concept of NPV overboard because somehow I’m discounting the most nebulous possible kinds of cash flows. Further, it allows the manager to say that keeping his wife happy is a +NPV project for the company too because when his wife is upset, he can’t make any money for the firm and his wife can only be happy being paid $1M for emptying waste baskets (so she’s searching for the waste basket under the desk, huh?).
my bad. i quickly skimmed some of the posts and I thought you were talking about how to calculate NPV (lillie) and not really answering the question… i gotcha now… good illustration w/ the issue debt to repurchase shares example