NPV the Net Present Value Calculation Is Essay
- Length: 5 pages
- Sources: 5
- Subject: Business
- Type: Essay
- Paper: #2438202
Excerpt from Essay :
The net present value calculation is the best way to make a capital budgeting decision. NPV takes the incremental cash flows from a project and then discounts them to present-day dollars. This technique allows managers to not only identify the incremental cash flows associated with a project, but also allows them to discount future cash flows to present day, so as to account for the effects of inflation.
In this case, we have the following schedule of cash flows:
If T-Mobile is considering a project with these flows, and the company has a discount rate of 4%, then the NPV of the project would be as follows:
Thus, this project has a net present value of $ -170.68. A project should only be accepted if it has a positive net present value. The reason for this is that the discount rate effectively represents the opportunity cost of capital (Brealy & Myers, 1996). This means that the 4% rate we are using for T-Mobile represents what T-Mobile earns on its ongoing business. If the project has a positive NPV, the project earns more than the existing T-Mobile business; if it has a negative NPV, the project earns less than the ongoing T-Mobile business. Thus, a project with a negative NPV should be rejected because it would reduce shareholder wealth. A positive NPV represents a project that will enhance shareholder wealth. By agency theory, managers act as agents for the shareholders, and therefore should undertake actions in the best interests of the shareholders. It is assumed that shareholders would want to pursue actions that enhance the value of their investments. Therefore, managers should approve projects with positive net present values because those projects improve shareholder wealth. Thus, because this project has a negative NPV, it should be rejected because that represents a diminishment of shareholder wealth.
Another issue facing T-Mobile at present is a possible merger with Sprint Nextel. This issue has come into the public sphere by way of comments from the Sprint CEO (ABMN, 2010). Ultimately, for a merger to take place, the shareholders of both firms must benefit. There are a number of considerations that need to be analyzed here. The first is the impact on T-Mobile shareholders. T-Mobile is a subsidiary of Deutsche Telekom, so strategically DT would only accept the merger under two conditions. The first is if it wanted to exit the U.S. market, and the second is if it did not want to exit and was allowed to maintain a stake in the combined entity. But those are structural issues that can be worked out at a later point in time.
The more important consideration is the acquisition premium. It is assumed that T-Mobile is currently valued at its intrinsic value. That is, if T-Mobile was publicly traded, the company's value would correspond with the present value of its expected future cash flows. For shareholders of T-Mobile, any offer for takeover would have to exceed this amount in order for them to be enticed to sell out today. The amount by which the offer exceeds the intrinsic value of the firm is known as the acquisition premium. The acquisition premium varies depending on the deal. The average acquisition premium in 2006 was 21%, but it was 34% in 2009, so there is considerable leeway in setting an acquisition premium (Milano, 2011). For T-Mobile shareholders, the acquisition premium is an immediate benefit that they must receive in order for the deal to be accepted.
For Sprint shareholders, as owners of the acquiring firm, the deal must be worth paying the acquisition premium. Since the company is paying more than fair (intrinsic) value for T-Mobile, this implies that the combined company will need to be able to extract greater value than the acquisition premium. This is typically the result of "synergy," which can mean a lot of different things. In this case, the two companies are in the same business, so synergy most likely refers to lowering the fixed cost as a percentage of revenue, by way of improved economies of scale (McClure, 2012).
There are a number of opportunities for synergies here, if the two firms can combine their operations…