Measuring Investment Value: Free Cash Flow, Net Present Value, and Economic Value Added

Arnold, Tom; Nixon, Terry D.

doi:10.1002/9781118258422.ch4

Cited by 2 publications

(2 citation statements)

References 21 publications

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“…Arnold (2014) introduces a method of real options valuation in which the cash flows of a net present value (NPV) analysis are modeled in what is called an “NPV‐embedded” binomial tree. Arnold's method reflects the past work of Arnold and Nixon (2011), Hodder et al (2001), Hodder and Riggs (1985), and Hayes and Garvin (1982). This method allows an NPV analysis to be more dynamic than in a traditional static NPV model—where expected cash flows are discounted using a constant value for the discount rate much like valuing a bond by discounting its cash flows at the yield to maturity.…”

Section: Introductionmentioning

confidence: 91%

Embedding a net present value analysis into a binomial tree with a real option analysis

2022

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A net present value (NPV) analysis with associated financial statements is embedded into a binomial tree that allows the analysis to evolve through time and, at any given moment in time, to vary with different states of the world. The modeling of the cash flows within the binomial tree requires a variable component based on relationships with a specifically defined random variable and a component that is fixed at a given moment in time. Although after‐tax operating cash flows are used in this treatment with a real options example, the binomial tree method can be applied to other definitions of project cash flows.

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Section: Introductionmentioning

confidence: 91%

Embedding a net present value analysis into a binomial tree with a real option analysis

2022

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“…Some authors like Arnold and Nixon (2011) and Arnold (2014) have pointed out that the discount rate used in an NPV analysis is actually a summary or average rate used primarily for convenience of use on all the cash flows of a project, whereas the appropriate discount rates may actually be higher for later cash flows in line with their greater inherent uncertainty. These authors also pointed out that the discount rate in an NPV analysis is similar to the yield to maturity of a bond as "the discount rates that apply to the bond should differ based on when the coupon is received" (Arnold, 2014).…”

Section: An Expression For Risk Addendummentioning

confidence: 99%

An appropriate risk addendum for risky projects

Bhaumik

2016

Managerial Finance

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Purpose – Despite many troublesome aspects in its use, the risk-adjusted discount rate has survived and continues to be extensively used by practitioners. While the appropriate discount rate for projects as risky as the current business operations of the firm can be estimated relatively easily as the firm’s cost of capital, no clear guideline is available for projects with a higher risk profile. The purpose of this paper is to evaluate an appropriate risk addendum for such risky projects. Design/methodology/approach – Extending the framework developed by Davies et al. (2012), the perceived risk in a project is captured by focussing on a downside case scenario and estimating its probability and severity. An expression is then developed for the risk addendum (as an addendum to the firm’s cost of capital) that can be used to find the value of a risky project. Findings – The risk addendum is found to depend only on the product of the probability (p) and the severity (d) of the downside case scenario and not on either of them individually It was also found that the risk addendum rises fast for projects with shorter lives and so is the highest for risky projects with short lives. Practical implications – Managers can use the expression derived to evaluate an appropriate risk addendum for risky projects. Originality/value – The paper suggests a simple framework to quantify the risk involved in a project and to evaluate an appropriate risk addendum.

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Measuring Investment Value: Free Cash Flow, Net Present Value, and Economic Value Added

Cited by 2 publications

References 21 publications

Embedding a net present value analysis into a binomial tree with a real option analysis

Embedding a net present value analysis into a binomial tree with a real option analysis

An appropriate risk addendum for risky projects

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