What am I forgetting here? - Ex.) I invest in a company and my RROR (wacc) is 15% - thereby, I am expecting a return of 15% in exchange for my cash investment. If i use this rate to discount the future cash flow and get a PV=0, does this mean I am getting exactly 15% for my investment ?? If so, isn’t that a good thing, why reject that investment…that is what i required for the investment - aren’t I achieving a 15% return and thus adding value ? I guess my confusion stems from the obvious fact the investment is worth $0, so where is the return?? Thanks!
If NPV is 0, that means that you’re getting cash flows equal to your cost of capital in this case. You want to have a return higher than your cost of capital, otherwise why bother? You’re plugging in WACC to see if the cash flows hit your bare minimum return. I think this makes sense in my head but not sure if I’m explaining it correctly.
Yeah, if NPV is zero a firm would be indifferent to accept/reject since it doesn’t really add any net value to the firm or produce a loss on the investment. I think this is where accuracy of the projected cash flows really makes a difference. If you’re off a bit, that NPV=0 could turn out to be a loss or a gain depending on how far off the firm was in its projections.
If you borrowed at 15 percent to Invest in a project, then 15 percent is your required rate of return on the project. It means it’s the minimum amount you will accept that makes any sense. If your project returns 14 percent then you are making loses. Now if your project returns exactly 15 percent, then you aren’t making profit, neither are you making loses, all discounted cash outflows to the project is simply equal to the discounted cash inflows, the NPV is equal to zero, the project does not have any value. You need to earn something in excess of 15 percent for your project to make any economic sense.
But aren’t you still earning 15% and achieving the return you require ? And if so, where is that 15% reflected if the value=0??
Gothca. Sorry, I reposted without first seeing your post, bloodline. I guess the only other aspect that is confusing is in terms of valuing a company. If you discount at 15% and the PV=$0 , that means the stock is worth $0. So where is the 15% earned if the stock price =0 ?? To borrow from your example, if I borrow funds at 15% interest and invest in a company that i think is equally risky (ie use 15% discount rate), and the PV of future company cash flow = $0, then where is my cash to pay back on the funds i borrowed??
I will put it another way. Suppose you got 2 dollars loan from your local bank and you are to pay 15 percent interest on this loan… suppose you will also like to lend out this money to your friend who is excited to buy the latest Iphone, at Interest rate will you lend out this money to your friend? 1) If you lend the money out to your friend at 12 percent, then you are making losses, because you will have to repay the bank at 15 percent. 2) If you lend the money out to your friend at 15 percent, then you aren’t making any losses, neither are you making any gain, since you will have to repay the bank at 15 percent. 3) If you lend the money to your friend at 16 percent, then you have gained 1 percent from your investment, since your friend will pay you at 16 percent and you simply pay the bank at 15 percent. In this case, 15 percent is your required rate of return. It is the cost to you, for financing the project, (hence known as cost of capital), if you project simply returns this cost, then the value of the project is zero.
I suspect where the confusion may lie is in understanding the difference between Internal rate of return, required rate of return and the actual rate of return. I would suggest that you read the article in the link below, it is rather more explanatory and probably less confusing that any explanation i may want to put forward http://www.onemint.com/2010/11/23/what-is-irr-and-how-is-it-calculated/
Thanks for your patience. Your example helps, but still a little lost. Say you invest in a company and your WACC (RROR) = IRR = 15%. At 15% the PV of the company = $0, and thus each share you own = $0. If i borrowed funds @ 15% to buy shares and the company is returning 15% (know bc IRR=15%), then where is the money to repay the money i borrowed if share price =$0 ?? Perhaps the $0 stock price is the NPV to you, and the future cash flow is what you would use to repay the loan at 15% ??? Sorry to regurgitate only a slightly modified example.
WACC is cost which company is paying for its capital. NPV 0 means that the project is not adding anything additional to the firm. Whatever its earning is consumed in paying the cost. Firm is indifferent for investing or not when NPV is 0. If NPV < 0 then return is < WACC means that we are earning less and paying more and if NPV is > 0 then return is > WACC means that we are earning more and paying less thus the additional amount is adding value to the firm where as in previous case the return was deteriorating the value of the firm.
Yes, If the IRR to you equals your cost of obtaining capital, then the present value of the company today equals zero. So if you borrowed x dollars at 15 percent, and your Net present value equals zero (it’s simply saying you shouldn’t expect any profit in the project), then you will repay the x dollars you’ve borrowed in installments in the future, by using the cash flows from the project. If you borrowed 15 dollars from bank, which you will repay annually with 3.5 dollars over the next 5 years…if you invest this in a project that only returns 3.5 dollars annually over the next 5 years, then your value from the project equals zero, and your future cash inflows will simply be used to settle your initial cash outlay.
Thanks for the help, everyone!