The NPV Criterion for Valuing Investments under Uncertainty
Corporate finance theory has established four criteria for the valuation and selection of investments: the net present value (NPV) criterion, the internal rate of return (IRR) criterion, the payback period (PP) criterion, the profitability index (PI) criterion and the excess return (ER) criterion. Each of them has its advantages and disadvantages, which we will not insist upon in this paper. Instead, we shall emphasize some interesting properties of these indicators, based on the hypothesis of the (almost) normal probability distribution of the free cash flows generated by the investment. For this purpose we have considered 15 scenarios and we have simulated possible free cash flows generated by a 10-year investment project. Our study has led to the conclusion that the indicators NPV, IRR, PP, PI and ER are approximately normally distributed, which simplifies substantially the analysis of investments under uncertainty conditions and enables us to build confidence intervals and to estimate probabilities for the lower limits of the aforementioned indicators. At the same time, our study addresses the controversial issue of computing the expected value and the standard deviation of the net present value of an investment under conditions of uncertainty.
The NPV Criterion for Valuing Investments under Uncertainty.
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The NPV Criterion for Valuing Investments under Uncertainty.
Autori:
Daniel
Armeanu
Rezumat
Corporate finance theory has established four criteria for the valuation and selection of investments: the net present value (NPV) criterion, the internal rate of return (IRR) criterion, the payback period (PP) criterion, the profitability index (PI) criterion and the excess return (ER) criterion. Each of them has its advantages and disadvantages, which we will not insist upon in this paper. Instead, we shall emphasize some interesting properties of these indicators, based on the hypothesis of the (almost) normal probability distribution of the free cash flows generated by the investment. For this purpose we have considered 15 scenarios and we have simulated possible free cash flows generated by a 10-year investment project. Our study has led to the conclusion that the indicators NPV, IRR, PP, PI and ER are approximately normally distributed, which simplifies substantially the analysis of investments under uncertainty conditions and enables us to build confidence intervals and to estimate probabilities for the lower limits of the aforementioned indicators. At the same time, our study addresses the controversial issue of computing the expected value and the standard deviation of the net present value of an investment under conditions of uncertainty.
Cuvinte cheie:
net present value, cash flow, discount rate, uncertainty, normal distribution, confidence interval, expected value, standard deviation of the net present value
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