* A NAIRA TODAY IS WORTH MORE THAN A NAIRA RECEIVED TOMORROW AND A SAFE NAIRA IS BETTER THAN A RISKY NAIRA” – https://wordpress.com/post/optionxpress.wordpress.com/297
It is better to buy an asset that is worth more than its cost. Before investing, especially in an asset, it is important to determine the value; how much the asset is worth. How then can we know the value of an asset? To explain this, we are going to use these four Investment Principles:
1. A Naira today is worth more than a Naira received tomorrow.
2. Safe investment is better than a risky investment
3. Invest in an asset or investment or business if the Net Present Value (NPV) is positive.
4. Invest in an asset or investment or business if the return of investment (IRR) is higher than the cost of capital.
A Naira today is worth more than a Naira received tomorrow” Assuming you invested N35,000,000 for the purchase of a house and you expect or has been advised that the house will fetch N40,000,000 in cash flow a year from the date of investment. If eventually, you sold the house for N40,000,000, you will be investing N35,000,000 to make N40,000,000 with a net of N5,000,000. This investment would only be worthwhile if the present value of this N40,000,000 is higher than N35,000,000. Consequently, the N5,000,000 is not the payoff. To get the payoff, you have to work out the Present Value of the Payoff (N40,000,000) one year from now, which has to be less than N40,000,000 after all a Naira today is worth more than a Naira tomorrow, because a Naira today can be invested to start earning interest immediately, justifying the first principle.
This present value of a delayed payoff can be gotten by multiplying the payoff by a discount factor, which is less than one. The Discount factor is the value today of N1 received tomorrow and the formula is 1/(1+r); where r is the rate of return; which is the reward investors accept for delayed payoff/payment. The present value of an asset is the discounted cash flows the asset is expected to generate within its estimated useful life. Cash flows here mean the difference between the inflow and outflow. When the present value is deducted from the initial investment, it gives the net present value and if positive, it is a good investment; satisfying the third principle
To actually determine if our investment of N35,000,000 is good for a payoff of N40,000,000, we can value the investment by discounting the N40,000,000 with opportunity cost of capital. Assuming the N40,000,000 payoff is a sure thing (though this is not usually the case), we discount using the rate of return of a risk-free asset/securities like Federal Government Treasury Bills or Bonds as our opportunity cost of capital. Because our investment horizon is one year, we use 364-TB; Auction date of November 14, 2018 rate of 14.56% as our discount rate. So, at an interest rate of 14.56%, the present value of our N40,000,000 a year from now is N34,916,201.12 (40,000,000/(1+.1456)). This means, at the point you are investing to receive the N40,000,000 in a year’s time, the value of the asset is N34,916,201.12, which is also the market value. To arrive at the NPV, you deduct the initial investment of N35,000,000 from the present value of N34,916,201.12 to get NPV of –N83,798.88. Following our 3rd principle, this is not a good investment.</p>
<p style=”text-align:justify;”>Remember, that the risk element was not factored in our calculation. The expected payoff (N40,000,000) may not be a sure thing and if there would be a variation, our calculation of the NPV would be wrong. Because of this inherent risk, we invoke the second principle, which is a safe Naira is worth more than a risky Naira. Notwithstanding, our concept of present value and opportunity cost still make sense. What is required is to discount at appropriate rate of return offered by equivalent investment. Not all investments are equally risky. Some are riskier than others. Assuming real estate investment is as risky as the stock market, which offers expected return of 20%, we can then recalculate the NPV to arrive at –N1,666,666.67 (40,000,000/1.20) – N350,000,000. So the value of the property is N33,333,333.33, consequently, you cannot sell the property above this value.
Arriving at a value of an investment depends on the timing of the cash flows and their certainty. Determining the timing of cash flows and their uncertainty is not as easy as prayed. But one important thing to note is that if the return on investment is more than the cost of capital, then it is a good investment satisfying the fourth principle.
From a layman’s point of view, using our example, the rate of return is simply the profit as a proportion of the initial outlay, which is 40,000,000 – 35,000,000 /35,000,000 = 14.3%. On the other hand the cost of capital is the return foregone by not investing in the risk-free security (FG TB or bond) or not investing in stock, if it is deemed riskier than investing in TBs. Since the rate of return is less than the 14.56% (if invested in TBs/Bond) and 20% (if invested in stock), it is then not a good investment.
The then challenging issue is how to get the opportunity cost of capital (discount rate). Discount rate is determined by prevalent rate of return in the capital market. If the future cash flow is safe, then the discount rate is the interest rate on sale of FGN treasury bills or bonds. If the size of the future cash flow is uncertain, then the expected cash flow should be discounted at the expected rate of return offered by equivalent securities. You select a similar asset with same risk profile and determine the return on that asset, using dividend discount model, capital asset pricing model, etc. For example, if Dangote Cement is trading at N205/share and is projected to trade at N235/share and pay a dividend of N2/share by next year, expected return = expected profit / investment, which is 2+235 – 205/205 = 15.61%. This is the expected return you are giving up by investing in our building rather than the Dangote Cement stock. In other words, it is the opportunity cost of capital. So to value the investment, discount the expected cash flows or payoff by the opportunity cost of capital. Already explained, cash flows are discounted because a Naira today is worth more than a Naira tomorrow and secondly a safe Naira is better than a risky one. Capital market is still a better place to pick your discount rate because it is a place where safe and risky assets are traded.