For the purposes of evaluating a proposed investment, the best existing tool until yesterday was the “Net Present Value” method (NPV). For more information on NPV and Financial Analysis, please follow these links on Wikipedia: http://en.wikipedia.org/wiki/Net_present_value http://en.wikipedia.org/wiki/Financial_analysis Problems and inaccuracies of NPV The inaccuracies of the NPV method are so many and obvious, that they can be spotted even by people without Accounting or Finance backgrounds. The most obvious is that the Bank account’s balance on some days is a negative value (loan), and accordingly produces Interest Expense (for example at 6%), while on other days the balance is in our favour (savings) and produces Interest Income thru the application of an interest rate far smaller than that of lending (for example at 0.5%). The NPV method uses only one discount rate, and so in effect treats in the same manner two materially different situations (Interest Expense at 6% and Interest Income at 0.5%). It is worth to be noted that the interest bearing balance is not the same with the accounting balance, but it is calculated after we take into consideration the interest bearing value date of transaction (a.k.a. valeur date) and after we also take into consideration intervening holidays and weekends. The method of NPV, on one hand is unable to determine both daily balances (accounting and valeur), and on the other hand it is unable to determine in which incidents we must apply which of the two interest rates. Accordingly inability of determination of the precise balance means inability of accurate calculation of sum of interest. That is only a small taste of the legion of problems and inaccuracies that are built in the NPV methodology. Why NPV is practically unreliable for investment evaluationLet us say that, in spite of the numerous shortcomings, we still want to evaluate a proposed investment thru NPV and a spreadsheet. We mark a cell in which we will put the discount rate that will be used, and we fill in the relevant forecasts. After we have finished the data entry, the next and last step is to begin debating with the rest of the project team which discount rate should be used. Suppose that in a particular scenario you find out by testing values in the discount rate cell, that at 3% your result is profit, at 4% is loss and at 3.57% you have break even. Which rate should be chosen by the team? The debate on this could be endless. However the most bothersome part is that there is no justification (that can stand up to scrutiny and verification) for any choice. So the question whether the choice was influenced by one’s desire to cook up the result in order to make it look like a profit maker or a loss maker goes unanswered. The “profit or loss” result should be a product of a verifiable calculation, and not of concession, or of bending the numbers so that they fit to one’s wishes. One of the most extreme examples of the unreliability of the NPV methodology is the “three investment scenarios” case. Prepare yourself to have a good belly laugh when you realize the kind of illogical result that can be obtained thru NPV in the following case. The “three investment scenarios”Let us say that an investor is evaluating (thru the use of NPV) to invest in the creation of a new company that will manufacture and sell a new product. After all relevant forecasts (sales, purchases, salaries, ads etc) are collected, they are entered in a spreadsheet and they are discounted to their value on the starting day of the investment. The collections are portrayed as positive while the payments are negative. In the end all discounted values are added, and we see if the result is positive (profit) or negative (loss). On that we base our decision whether to make the investment or not, Low scenario The investor contributes 1 million EUR as equity. The project is underfunded, and accordingly will take bank loans to fund its operation. The result is that half of the gross profit will go to payment of Interest Expense (at 6%). High scenario The investor contributes 10 million EUR as equity. The project is self sufficient and does not need bank loans. On the contrary it will collect some Interest Income (at 0.5%). Mid scenario The investor contributes 5 million EUR as equity. The project will take smaller bank loans than the low scenario and accordingly pay less Interest Expense (at 6%) than the low scenario, and will collect less Interest Income (at 0.5%) than the high scenario. Concerning the bottom line result, which is year end “profit or loss” (or even better, if you prefer, dividends distributed), we see three materially different results. All of the forecasts (sales, purchases, expenses etc) are the same in all three scenarios. Their only difference is the starting balance of the bank account (as it is affected by the investor’s contribution of equity). With the use of NPV all three scenarios deliver the same result. The problem lies in the fact that the starting balance of the bank account (or for the matter its balance at any given moment) is not factored or calculated anywhere. There are two ways to attempt to restore some semblance of sanity to this obviously incorrect and illogical result. However none of them will deliver a result that is reliable or accurate. Attempt 1: Use a different discount rate for each scenario The problem is that a method to establish an appropriate rate (that will be able to pass scrutiny and verification) does not exist. In effect, the only way to name a discount rate is by “pulling numbers out of thin air” or by the “concession method” that was previously mentioned. That is the financial analysis word’s equivalent of what in the accounting world is known as “cooking up the books” or “number juggling”. Attempt 2: Calculate interest on the basis of a monthly average balance In other words, we say that this month’s forecasted collections minus this month’s forecasted payments plus the previous month’s monthly average balance equals this month’s monthly average balance. Or in other words, this method is saying that on average, everything is assumed to happen on the 1st day of the month. Anyone who has a basic knowledge of what a company’s cashflow needs look like will immediately understand that this has no connection with reality. In reality, on some days the bank account’s balance is in our favor (debit balance – Interest Income at 0.5%) and on some it is against us (credit balance – Interest Expense at 6%). That sort of effect cannot be calculated with that method, because what is being assumed is a steady monthly balance. Let’s not even start discussing the effect of days of valeur in the calculation of interest. By default that is unattainable and impossible. And the number of other shortcomings that one can mention which impair the result’s accuracy is legion. If a cashflow happens on day x, it has a different effect than if it happened on day x+10 or on day x10. With the monthly average method it has the same. The NPV method is used as a means to rationalize that illogical result. However in this situation (the “three investment scenarios”) by using an inferior methodology, and thus in effect taking a step back in financial analysis evolution, what is being achieved is a more logical result (albeit not an accurate or reliable one).
