From an investment prespective, why invest in, say, treasuries if it’s NPV = 0. If you buy a $1000 bond with a 4% coupon, by its nature (assuming you hold to maturity), its NPV=0 (PV cash inflow - initial $1000 outflow). If this is the case, what makes them a worthwhile investment?
Obviously, you make 4% and people invest in them, so what am i missing ? How are you actually earning 4% if it has a zero NPV , which means no value is actually being added?.
Sorry, all these formulas and information have started to cloud my thoughts, and confuse me on what should otherwise be simple stuff. Thanks in advance.
The NPV is essentially the excess return over your discount rate. Just because the NPV is zero does not mean your return is zero. If you buy something that is returning 5% with a 4% cost of capital the NPV will be positive. If you buy something else that is returning 3% with a 4% cost of capital the NPV will be negative. You will still have positive returns in these scenarios, but very different NPVs.
Thanks, Chad! One other quick example. If you’re company invests in a machine and the return your company generates by operating that machine is 15% annually, which happens to match your company’s cost of capital, that mean’s you’re company is making 15% a year…it’s just not adding any actual value to the firm, right??? Just seems odd when you’re returning 15% (or anything for that matter) yet you’re adding no value.
realize that to meet the 15% cost of capital requirement year after year, the company has to do lots… you are making an investment now, and you expect that project to last years. … which does not happen without effort. if you make a return higher than what you spent - you make profits. even if you broke even, it is only after all the costs (expenses) have been incurred and covered. only after that can you say you managed to meet the cost of capital requirement. You have added value there itself by not making less on your investment than what was spent on it.
In terms of a stock price, however, breaking even would not increase the stock price (theoretically). It has value to the extent that it does not decrease your stock price, but it should result in a price equal to that which existed prior to starting the project, no? You may have added/returned 15% that year but if that’s what is required than no incremental value is created. Is this understanding correct? I guess the thing that confused me was seeing NPV=0 and thinking that meant it wasn’t worth anything / the stock price is 0 / no return is being made. But it’s really that no incremental return is made…what you expected (and realized) equaled what was required. However, you still made that expected return, which is positive. Am i off base?
Another way to think about it is that if you don’t invest the money you lose (opportunity cost) the return of the investment. This could be required return in the case of projects, or when you look at risk free, essentially you are investing to hedge inflation