Net Present Value and Other InvestmentCriteria As we have already established, the manager's main aim is to maximise shareholder wealth.

As we have already established, the manager's main aim is to maximise shareholder wealth. In order to maximise shareholder wealth, managers must choose investments that will increase the return to their shareholders and the value of the firm. Investments must be chosen that will provide value to the owners.

There are numerous measures that allow a firm to establish the viability of a project. These measures include the payback period—which is considered the most simplistic measure; however, it does not take into account the discount value of future cash flows—the discounted payback period, the accounting rate of return, the NPV and the IRR. While all these methods have advantages and disadvantages, the NPV and the IRR are among the most accurate and provide the most relevant information.

Shareholder wealth or value can be created by choosing investments that have a positive NPV—that is, the value of the investment in today's dollars outweighs the costs of the investment also calculated in today's dollars. For an investment decision to be considered viable, the NPV value must be positive, because only when the NPV value is positive will the desired investment add any value to the firm. The NPV can be described as the measure of how much value is created or added by undertaking this particular investment.

The IRR is a measure that is linked quite closely with the NPV, and it is also considered a desirable measure in relation to the viability of an investment decision. The IRR can be described as the discount rate that makes the NPV of an investment zero. When using the IRR method as a choice for investment decisions, we may only select the investments that produce an IRR figure that is higher than our required return.

The article 'Discounted cash flow and other valuation tools' appeared in the Sydney Morning Herald[1] on 27 September 2003 and demonstrates the value of discounted cash flows and their use in predicting which stocks will appreciate in the future. This method of discounted cash flows allows fund managers to predict the direction of future stocks, by predicting what their value should be by looking to their future cash flows, discounted for today. This in turn should provide intrinsic value to the fund shareholders.

Question 1 (5 marks)

List the methods that a firm can use to evaluate a potential investment.

Question 2 (5 marks)

Why is the NPV a preferred method when evaluating a potential investment opportunity?

Question 3 (10 marks)

What is the IRR? How is it related to the NPV? Is the IRR always an effective method when evaluating a potential investment opportunity, and why?

Question 4 (20 marks)

Using the article from the Sydney Morning Herald, discuss why John Whiteman, the senior portfolio manager at AMP Henderson, can be considered 'skilled' in respect of his stock pickings. Why would it benefit fund managers to use discounted cash flows when picking stocks?

Question 5 (30 marks)

A firm that pays out 65% of its earnings as dividends has an accounting rate of return of 20%. Its P/E ratio is 10 and its earnings per share is 108 cents.

(i)                What is the price per share?

(ii)              What is the dividend yield?

(iii)            If shares were bought, what would be the payback period? Assume the only return is the dividend.

(iv)            What is the net book value per share of the asset investment of the company?

(v)              If the risk-adjusted required rate of return is 6%, what would be the NPV per share for buying shares?

(vi)            Would you buy shares using AROR or NPV?