Net Present Value of Growth

In order for a company to calculate what the new addition or expansion project will add to the worth of the existing firm, it needs to calculate the present value of growth opportunities. Furthermore, an appropriate purchase price can be calculated by utilizing the present value model. The net present value of growth opportunities can be determined by deducting purchase price from the present value of growth opportunities.

The technique utilized is to discount costs and benefits that occurred in different time periods and express them as a single value at a specific point of time. If the discounted value of the costs is greater than the discounted value of the benefits-that is the net present value (NPV) is negative-the project should be rejected. However a project of positive or zero NPV may reflect an absence of alternative projects rather than a valuable project.

This is because the shadow prices of land or a site value is quite impossible to estimate independent of the project appraisal process. Therefore, it is highly likely that the opportunity costs of such inputs are underestimated because of a lack of identification of their best alternative use. A good way to determine the relevant alternative use is to carefully analyze all conceivable projects.

Additionally, care needs to be taken in case of mutual exclusiveness of projects. That is, only one project out of two can be selected. In such cases, it is not sufficient to choose a project with a positive net present value. Selecting the project with the highest NPV of all alternative projects is what will be beneficial.

There can be some other ways of selecting or rejecting a project too, if, say, the investment budget is to be reduced or expanded. The change in budget leads to change in shadow rate of interest and consequently change in other prices, which affects NPV of projects in a different way. In this scheme, some projects earlier rejected in the earlier set of projects may get accepted whereas the ones with high NPV may drop out.