Net Present Value (NPV) Analysis of Severn Trent Plc

1. Introduction

1.1 Time Value of Money

Most people are aware that money in hand is more precious than the money collected in the future. We can utilize it to run a business, buy something now and sell it later for a profit, or just put it in the bank to generate interest. Future currency is also worth less since inflation erodes its purchasing power(Gallo, 2014). This concept is known as the time value of money. But how precisely do we compare the present worth of money to its future value? Herein lies the role of net present value(Dan, 2013).

1.2 Need of NPV

Net present value is the present value of the cash flows of an Severn Trent Plc project at the needed rate of return relative to the initial investment(Gallo, 2014).

It is a method for determining the return on investment, or ROI, for a project or expenditure. Severn Trent Plc can determine whether the project is worthwhile by calculating the investment's expected returns in today's dollars and comparing them to the project's cost(Dan, 2013).

2. Desirability of NPV

Internal rate of return, payback method, and net present value are the three options typically offered to Severn Trent Plc's Company manager when comparing projects and deciding whether to pursue. The majority of financial experts choose to use the net present value, also known as NPV. That is the case for two reasons, which are elucidated in the subsequent paragraphs.

2.1 The advantage over Payback Method

First, NPV examines the time value of money by transforming future cash flows into present-day dollars. Two, it provides a precise figure that Severn Trent Plc may use to compare initial cash spent with the present return value (Dikov, 2020).

According to the co-founder and proprietor of business-literacy.com, it is vastly superior to the payback approach, which is the most prevalent(Knight, 2014).

The allure of payback is that it is easy to compute and comprehend: when will Severn Trent Plc recoup its initial investment? It does not, however, account for the fact that the purchasing power of money today is larger than that of the same amount of money in the future. According to Knight, this is why NPV is the preferable method (2014).

2.2 Convenience of Use

Thanks to financial calculators and Excel spreadsheets, NPV is now that simple to compute. Severn Trent Plc can also utilize NPV to determine whether or not to make significant acquisitions, such as equipment or software. Severn Trent Plc Companycan also utilize it in mergers and acquisitions, albeit, in this case, it is referred to as the discounted cash flow model. In fact, this is the methodology that Warren Buffet employs when evaluating businesses. NPV is an excellent choice if a corporation uses present-day dollars to estimate future returns(Knight, 2014)

3. Procedure

3.1 Discount Factor

The discount factor formula provides a method for determining the net present value (NPV) for Severn Trent Plc. It is a weighted word used in mathematics and economics to identify the precise factor by which the value is multiplied to get at the net present value as of today.

This is widely used in corporate budgeting to analyze whether a proposal would bring future value.

3.2 Difference between Discount Rate and Discount Factor

Any discount factor equation assumes that money will be worth less in the future owing to causes such as inflation, resulting in a discount factor value between zero and one. The discount factor and discount rate are closely connected; however, whereas the discount rate considers the present value of future cash flows, the discount factor applies to the net present value.

With these numbers, Severn Trent Plc can predict the predicted earnings or losses of an investment and its net future value.

3.3  Formula

The formula Severn Trent Plc can use for the general discount factor is (Thakur, 2018):

Discount Factor= 1/(1*(1+Discount Rate)^(Period Number) )

3.4 Methodology

To utilize this formula, the periodic interest rate or discount rate must be determined by Severn Trent Plc. This is simply calculated by dividing the yearly discount factor interest rate by the number of annual payments.

Additionally, Severn Trent Plc will want the total number of payments that will be paid. To perform these computations, Severn Trent Plc can generate a discount factor template or table in Excel by inserting the aforementioned formula with our own values. Severn Trent Plcwill compute it the following way:

This demonstrates the diminishing discount factor with time, whether it is an annual discount factor or a shorter time frame to match our accounting period. This applies whether the time range reflects an annual discount factor or a shorter time frame.

For instance, to determine the discount factor for a cash flow that will occur one year from now, all that needs to be done by Severn Trent Plc is divide one by the interest rate plus one. If the interest rate was 5%, the discount factor would be calculated as 1 less than 1.05, which is equivalent to 95%.

3.5 Usage in NPV Analysis

After Severn Trent Plchas computed their discount factor and discount rate, they will be able to apply these two factors to the problem of determining the net present value of an investment. The total present value of all positive cash flows should be added together, and the total present value of all negative cash flows should be subtracted.

After making the appropriate calculations using the interest rate, Severn Trent Plc will arrive at the net present value. Many discount factor calculators available online will apply these formulas; alternatively, Severn Trent Plc may perform an analysis using Excel.

4. Net Present Value

4.1 Case 1: Variable Cash Flow

Calculating both the expenses (which result in negative cash flows) and the benefits allow Severn Trent Plcto arrive at the Net Present Value of a series of cash flows (positive cash flows).This is accomplished by the utilization of the following formula(Indeed Editorial Team, 2021):

NPV= ∑_(t=0)^n▒〖CF〗_t/〖(1+i)〗^t

Where CFt denotes the cash flow during the period, n is the total number of periods, t denotes the currently active period, and I represent the discount rate of Severn Trent Plc(Dikov, 2020).

4.2 Case 2: Constant Cash Flow

The following is an example of a basic finite geometric series that may be used to express the formula if Severn Trent Plc projects a consistent cash flow year after year(Indeed Editorial Team, 2021):

NPV= CF*((1-(1/(1+i))^(n+1))/(1- (1/(1+i)) ))

Where CF represents the continuous cash flow throughout each period, n represents the total number of periods, and I is the discount rate for Severn Trent Plc(Dikov, 2020).

5. NPV in Capital Budgeting

5.1 Nature of the Project

Before Severn Trent Plc can use net present value to evaluate a capital investment project, we will first need to determine if the project in question is independent or part of a chain of mutually exclusive projects (Taylor, 2017).

5.1.1 Independent

It refers to endeavors that are not influenced by the revenue flows generated by other initiatives.

5.1.2 Mutually Exclusive

If two projects are mutually exclusive, it indicates that there are two approaches to achieve the same outcome and cannot be done simultaneously. For example, it's possible that Severn Trent Plc may request bids on a certain project and that they've gotten several of those bids.

Severn Trent Plc should avoid the temptation to take two different bids for the same project. That illustrates a project that cannot coexist with another(Carlson, 2021).

5.2 Decision Rules

Every approach to budgeting capital expenses includes a list of decision rules. For instance, the decision rule for the payback period approach states that Severn Trent Plc must agree to move forward with the project if it is able to earn back its initial investment in a predetermined amount of time(Luehrman, 2016).

The same decision rule should be used when applying the discounted payback time technique. The concept of net present value comes with its own set of decision criteria, which are as follows:

5.2.1 Case 1: Independent Project

Severn Trent Plc should accept the proposal if the NPV is larger than zero.

5.2.2 Case 2: Mutually Exclusive Projects

If the net present value (NPV) of one project is larger than the NPV of the other project, then Severn Trent Plc will accept the project with the higher NPV. If both initiatives' net present value (NPV)s negative, then neither project should be pursued(Tamplin, 2021).

Consider the following scenario as we go through the process:

5.3 An Example

Let's say that the Severn Trent Plc is thinking about two different initiatives: A and B. Severn Trent Plc’sCompanycost of capital for each individual project is ten percent, and the initial investment is ten thousand dollars.

Severn Trent Plc is interested in determining and analyzing the difference in the net present value of these cash flows between the two projects. Every project has a different pattern of incoming funding. To put it another way, the cash flows do not constitute annuities.

5.3.1 Cash Flows

Severn Trent Plc wishes to compute the NPV for each project. The cash flows in each of the four years of Project A are as follows: $5,000, $4,000, $3,000, and $1,000, respectively. Project A is a four-year endeavor. The cash flows in each of the four years of Project B are as follows: $1,000, $3,000, $4,000, and $6,750, respectively. Project B is also a four-year Endeavor.

5.3.2 Calculation

To calculate the NPV of the project, Severn Trent Plcstarts by adding the cash flow from Year 0, which represents the initial investment in the project, to the cash flows from the remaining years of the project.

The original investment results in a negative cash flow and is therefore expressed as a negative figure. In this illustration, the cash flows for each project for years 1 through 4 are all exemplified by positive numbers.

To get the NPV for Project A, Severn Trent Plcfollows these steps:

NPV(A) = (-$10,000) + $5,000/(1.10)1 + $4,000/(1.10)2 + $3,000/(1.10)3 + $1,000/(1.10)4

The NPV of Project A is $716.54, which indicates that investing in the project increases the firm's value by $716.54.

For Project B:

NPV(B) = (-$10,000) + $1,000/(1.10)1 + $3,000/(1.10)2 + $4,000/(1.10)3 + $6,750/(1.10)4

Since Project B has a higher NPV than A, Severn Trent Plccan safely choose Project B instead of A based on our analysis.

6. NPV in Stock Valuation

The most popular approach for evaluating the value of Severn Trent Plc shares is the Discounted Cash Flow (DCF) model, which employs Net Present Value (NPV) in its calculation. The DCF model methodology is explained below.

6.1 Initial Steps

Beginning with the revenue statement of Severn Trent Plc, we project future (typically five) years' income and expenses(Probasco, 2021). Then, projections are made for fixed assets and changes in the working capital of Severn Trent Plc

. The second level is capital structure projection. Depending on the type of DCF model being constructed, the most frequent strategy is to maintain the Severn Trent Plccurrent capital structure, assuming no major changes other than those that are known, such as debt maturity(CFI, 2022).

6.2 Terminal Value

The terminal value, a crucial component of a DCF model, is then calculated. It frequently accounts for more than 50 percent of the Severn Trent Plcnet present value, especially if the forecast term is five years or less. There are two methods for calculating the terminal value: the perpetual growth rate method and the exit multiple methods (Matthiessen, 2019).

6.2.1 Perpetual Growth Rate Method

The perpetual growth rate method assumes that the cash flow created at the end of the projected period rises at a constant rate in perpetuity. Consider that another company is looking to acquire

Company Severn Trent Plc, whose cash is $10 million, grows at a rate of 2% indefinitely, with a cost of capital of 15%. $10 million / (15 percent - 2 percent) = $77 million is the terminal value.

6.2.2 Exit Multiple Method

Using the exit multiple method, it is assumed that Severn Trent Plcwas sold for the price that a reasonable buyer would pay. This often entails an EV/EBITDA multiple equal to or close to the current market values of comparable companies. As seen in the following example, if Severn Trent Plc has $6.3 million in EBITDA and comparable businesses are trading at 8x, then the terminal value is $6.3 million x 8 = $50 million.

6.2.3 Decision

If we want to determine the equity value of Severn Trent Plc, we must adjust the net present value (NPV) of the unlevered free cash flow for cash and equivalents, debt, and any minority stake(Ahern, 2022). This yields the equity value, which may then be divided by the number of shares to obtain the share price. Then, we may determine whether the stock of Severn Trent Plcis overvalued or undervalued and decide whether to purchase or sell it.

7. Assumptions

Even though the discounted value of future cash flows is not a statement that non-financial individuals easily utter still, it is worthwhile to explain and present NPV due to its superiority, as any investment that passes the net present value test will improve shareholder value. In contrast, any project that fails would actually harm the company and its shareholders if carried out anyhow(Entras, 2016).

There are three potential estimation errors that will have a significant impact on the final outcomes of our calculation.

7.1 Initial Expenditure

First, there is the initial expenditure(Kristiani, 2022). Does Severn Trent Plc know how much the project or expense will cost? There is no risk when purchasing a piece of equipment with a visible price tag. But if Severn Trent Plc is modernizing its IT system and estimating staff time and resources, the project timetable, and how much it will pay external vendors, the numbers can vary significantly(Jones & Smith, 1982).

7.2 Discount Rate

There are further dangers associated with the discount rate. Severn Trent Plc is applying today's rate to future returns, so there is a potential that, for example, in Year Three of the project, interest rates will skyrocket, and the cost of their money will increase(Ionos, 2019).

This would imply that Severn Trent Plc’sreturns for that year will be lower than anticipated.

7.3 Anticipated Returns

Third, Severn Trent Plc must be confident in the anticipated returns of the project(Mendell, 2020). These forecasts are typically optimistic since people want to complete the project or purchase the equipment(Bey, Doersch, & Patterson, 1981). This, however, can lead to erroneous NPV calculations.

8. Sensitivity Analysis

Given that the computation is based on a number of assumptions and approximations, there is a considerable possibility of a mistake. After our initial computation, Severn Trent Plc can mitigate the risks by double-checking our calculations and conducting sensitivity(Borgonovo & Peccati, 2004). The following is one illustration:

8.1 An Example

Cash Flow projections for the following 12 years are offered for Company Severn Trent Plc(see below). Capital cost is eight percent. Assuming the variables remain constant, we calculate the Severn Trent Plc’s Net Present Value (NPV).

9. Conclusion

NPV's significance in predicting the future of Severn Trent Plc and its projects is undeniable and an indispensable tool within the field of Financial Analysis. However, it must be remembered that it is expressed in absolute rather than relative terms and hence does not account for the magnitude of the investment, Severn Trent Plc opportunity costs, or the project's duration. In light of the limitations and benefits of NPV, it is imperative for Severn Trent Plc not to rely solely on it and to undertake assessments using alternative approaches, such as IRR, to be certain.