Net Terminal Value

1. Introduction

The Terminal Value (TV) method evaluates investments by explicitly considering the reinvestment of cash inflows at a certain rate of return until the end of a project. This approach contrasts with the Net Present Value (NPV) method, where cash flows are discounted back to their present value. The NTV method focuses on the compounded value of cash flows at the end of the project and then discounts that single terminal value back to the present.

2. Methodology

The Terminal Value (TV) approach assumes that each cash inflow is reinvested at a specified rate of return from the moment it is received until the end of the project. This process involves two key steps:

1. Compounding of Cash Inflows:
   • Each cash inflow is compounded forward at its respective reinvestment rate to the end of the project.
2. Discounting of the Terminal Value:
   • The sum of all compounded cash inflows (the terminal sum) is then discounted back to the present using the firm's cost of capital as the discount rate.

3. Example: Terminal Value Method

Let's assume:

• Initial outlay: Rs 10,000
• Project life: 5 years
• Annual cash inflows: Rs 4,000
• Cost of capital (k): 10%

Reinvestment rates:

Year End	Rate
1	6%
2	6%
3	8%
4	8%
5	8%

Step 1: Compounding Cash Inflows

Year	Cash Inflow	Reinvestment Rate	Years of Compounding	Compounding Factor	Compounded Sum
1	Rs 4,000	6%	4	1.262	Rs 5,048
2	Rs 4,000	6%	3	1.191	Rs 4,764
3	Rs 4,000	8%	2	1.166	Rs 4,664
4	Rs 4,000	8%	1	1.080	Rs 4,320
5	Rs 4,000	8%	0	1.000	Rs 4,000
					Total Rs 22,796

Step 2: Discounting the Terminal Value The total compounded sum is Rs 22,796. This is now discounted back to the present at the cost of capital, k (10%):

Present value of the terminal sum = Rs 22,796 * 0.621 = Rs 14,156.3

4. Accept-Reject Rules

4.1. Terminal Value (TV)

• Accept if PVTS > PVO: Accept the project if the present value of the total compounded sum (PVTS) is greater than the present value of the outflows (PVO), where PVO is the initial investment.
• Reject if PVTS < PVO: Reject the project if the PVTS is less than PVO.

4.2. Net Terminal Value (NTV)

• Definition: NTV = PVTS - PVO
• Accept if NTV > 0: Accept the project if Net Terminal Value (NTV) is positive.
• Reject if NTV < 0: Reject the project if NTV is negative.
• Indifference if NTV = 0 The firm would be indifferent if both the values are equal.

In our example, the PVTS is Rs 14,156.3 and the initial outlay (PVO) is Rs 10,000, therefore, the project would be accepted. The NTV is 14,156.3 - 10,000 = Rs 4,156.3, so the project is acceptable.

5. Evaluation

5.1. Advantages

• Explicit Reinvestment Assumption: It explicitly considers how cash flows will be reinvested and does not assume they would be reinvested at the IRR. This helps avoid conflicts due to inconsistent re-investment assumptions.
• Mathematical Simplicity: It can be computationally easier than other techniques.
• Understandable: TV is easier for business executives to grasp than NPV or IRR, because the concept of "compounding" seems more intuitive than "discounting".
• Suited to Cash Budgeting: It aligns well with cash budgeting requirements as it displays all cash flows, including any interest earned due to reinvestments.

5.2. Limitations

• Projecting Future Rates: It's difficult to accurately predict the future reinvestment rates at which the intermediate cash flows will be invested. This may be a key limitation in times of uncertainty.
• Results Similar to NPV: If the compounding rates used for the terminal value are the same as the discount rate used for the present value, then NTV and NPV will give the same results.

6. Relationship Between NTV and NPV

The NTV method is similar to the NPV method. While NTV compounds the cash inflows to the end of the project's life and then discounts that single sum, NPV discounts each individual cash flow back to the present. Both methods will produce the same result if the same discount rate (or rates) is used for both compounding and discounting.

7. Conclusion

The Net Terminal Value method is a valuable capital budgeting technique that offers a different perspective on investment evaluation by focusing on the terminal value of cash flows. It is a robust method, that considers cash reinvestment, and can be simpler to understand, however it still has the key limitation of requiring accurate estimation of future interest rates. Like all techniques, the method must be used with caution, and decision makers should understand the limitations.