Financial Modeling Guide

To make sensible investment decisions, a good financial analyst should use a method that considers all of the costs and benefits of each investment opportunity, and makes a logical allowance for the timing of those costs and benefits. The net present value (NPV) method provides for these investment assessment criteria. The NPV is a financial valuation concept that is essential to all financial modeling projects.

The NPV of an investment is the present value of its cash inflows minus the present value of the cash outflows. Why would $100 to be received in a years time be as unequal in value to $ 100 to be paid immediately?

The 3 major reasons are:

• Interest Lost
• Risk
• Effects of inflation

The steps involved in computing NPV are:

1. Identify all cash flows
2. Determine, r, the discount rate
3. Using discount rate, find PV
4. Sum all PVs
5. Apply NPV rule. If NPV is positive, investor should undertake it else not undertake

This simplified formula illustrates the NPV method:

PV of the cash flow of year n = Actual cash flow of year n / (1+r) ^ n

The basic rule for NPV is that if the project shows a positive NPV, we need to accept the project. This is because the underlying rule is that if a project has a positive NPV it increases the shareholder wealth because all money goes to investors.

The NPV decision rules are:

• Projects with positive NPV should be accepted
• Projects with negative NPV should be rejected
• In case of mutually exclusive projects, the one with higher NPV should be selected

When the project NPV is zero, the rate at that point of time is considered to be its Internal Rate of Return (IRR).

The IRR decision rules are:

• Projects with an IRR which is better than that of the firm should be accepted
• Projects with an IRR which is less than that of the firm should be rejected

In case of a single project, the concluding decision will be the same in case of IRR or NPV.

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