4.3 Net present value
If the NPV is positive, then the aggregate present value of the future cash flows is greater than the price to be paid for the investment today, so the investment is cheap and offers an excess return. If the NPV is negative, then the price to be paid today is greater than the present value of the future cash flows; the investment is therefore overpriced and does not offer an adequate return. If the NPV is zero, we can say the investment is fairly priced by the market.
All significant financial decisions can be reduced to just two major questions:
Which projects should an organisation invest in?
How should an organisation procure the funds to pay for them?
We now have an answer to those questions. The NPV rule states simply that you should select investments with positive NPVs and reject those with negative NPVs, because the returns from the former exceed what is required to compensate you for the risks involved, whereas the latter do not.
Financing decisions, as well as investment decisions, have NPVs. If you pay investors in your organisation a higher return than is warranted by the risks they run, then the financing obtained from those investors has a negative NPV for you, just as it has a positive NPV for the lucky investors.
Positive and negative NPVs are less common in the markets for purely financial investments (or ‘paper assets’) than they are in the market for physical investments (or ‘real assets’). This is because the financial markets are generally more liquid and transparent than the markets for real projects: financial investments with positive NPVs are very quickly spotted by investors whose excess demand for them soon pushes up the price to the point where the NPV is again zero. This is summed up in the old adage: ‘There is no such thing as a free lunch.’ An investment seemingly offering an excess return – something for nothing – is likely to be a mirage.
Ed McHenry, Private Eye, No. 899 May 1996
It is considerably more difficult to identify, exploit and subsequently fine-tune investments in real assets with positive NPVs. It takes months or even years for an industrial company to exploit a market opportunity by building a new factory. If the factory turns out to be 20% larger than is justified by eventual demand, there is no easy or economical way for the company to adapt the scale of its investment to the changed conditions. A fund manager handling a large and diversified portfolio of shares, by contrast, enjoys continuous and almost infinite flexibility to adjust and fine-tune his or her investments.