In a
previous article (Investment Selection Based on
Returns) I said that the main advantage of the internal rate of return method
is that it is very easy to understand. We all easily grasp what it means that an investment has a particular
return (eg. 10% per year), and whether this is attractive when compared with
the minimum return compatible with the risk of the project.
Moreover, the results obtained with the NPV approach are more difficult to
interpret since these are absolute numbers whose meaning is unclear. In this
article I explain the meaning of the NPV
results. As usual I will resort to an example.
Imagine Albertico Limonta just inherited €90
thousand from his beloved grandmother. Albertico wants to mitigate his sorrow
using the inheritance money to buy a sports car, a Lamborghini.
Just when he was about to buy the car Albertico is
presented with a business opportunity. It consists in purchasing an apartment whose
value is expected to be €112 thousand within a year. The deal is that the property
can be purchased now for €90 thousand. The risk of this type of business
requires a discount rate (minimum return) of 12%.
Let´s calculate the NPV of this investment ,
NPV = -€90000+€112000/1.12 = +€10000
This is an attractive proposition because it
yields a positive NPV of €10
thousand.
Albertico is very tempted to do the business but
also wants to buy the Lamborghini. It seems that he will have to decide by one
thing or another. Well, incredibly, he must not! Actually Albertico can benefit
from the property deal and at the same time purchase the Lamborghini. Let's see
how.
The first thing Albertico must do is set up a
company that we will name Nauru Real Estate (NRE). Albertico transfers to the company the option to buy the property
for €90 thousand and in return becomes its sole shareholder. After this,
Albertico must find an investor who is willing to buy the shares of NRE.
Since the risk of this business requires a minimum
return of 12%, and the apartment is estimated to be worth €112 thousand within
a year, any investor will be willing to pay up to €100 thousand to own the
apartment. By becoming the sole owner of NRE
the new investor will have to pay €90 thousand for the property. So he will be
willing to pay up to €10 thousand to buy the shares (giving him the right to
buy the apartment).
Therefore, Albertico must sell the NRE shares for €10 thousand and buy the Lamborghini
with the €90 thousand inherited from his grandmother. What
is the result? Albertico gets the profit from the propertry deal and at the
same time has the pleasure of buying the car. The magic of finance has allowed him to "enjoy the cake without eating
it".
The NPV
of €10 thousand represents the "value" of the investment opportunity.
In other words, for how much a business deal can be sold to any investor willing
to settle for a reasonable return commensurate with the risk being taken. This
is how we should interpret the NPV.
This example also allows us to understand what the
key assumption behind the NPV method
is. For NPV to function a developed and
transparent capital market must exist permiting the sale of investment
opportunities to other investors with total freedom and without any barriers. Whenever
this condition is not met, the NPV rule is invalidated.
In my next article I will give an example of what
happens when the NPV rule can not be
applied.
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