NPV of a Perpetuity --> How to improve?

Corporate Finance NPV Valuation
New answer on Apr 30, 2020
5 Answers
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Anonymous A asked on Apr 09, 2020

Hi PrepLounge community,

I stumbled upon a difficult question in a recent case - looking forward to hearing your inputs on this!

Scenario (numbers are simplified)

- A tourism investment yields a positive cash flow of 15M every year, with no growth (perpetuity rent)
- We have an up-front investment of 100M
- Cost of capital = 10%
- NPV = -100 + 15/0.1 = 50M

Question and answer

Question
Your client is not satisfied by the NPV: 50M is too low. From a financial perspective, what could she do to improve the NPV to 100M?
And are these options difficult, medium or easy to implement?

Answer
We could:
i) Try to lower the cost of capital to 7.5% from 10%
--> By finding cheaper ways of financing such as public funding.
Level: medium, possible only if public funding is available or if we have debt in our financing mix.
ii) Try to have a constant growth rate of Cash Flow of ~2.5%
--> By increasing each year Q (thru occupancy) or P (thru added services)
Level: easy, it's doable to have a +2.5% in the first years of a new business
iii) Try to increase Cash Flow to +20M a year from +15M
--> By finding extra sources of revenues, even if gross margin is relatively reduced
Level: difficult, +33% a year is a huge increase if we keep the same biz model
iv) Try to reduce Capex to -50M from -100M
--> By drastically reducing infrastructure costs
Level: difficult, we can't expect the same level of revenues if we slash the quality/quantity of our infrastructure
v) A mix of these approaches

I feel like this is a very standard approach, I have no experience in finance. What would you add/comment to this answer?

Thank you in advance for your support!

Dee

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Luca
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replied on Apr 11, 2020
BCG |NASA | SDA Bocconi & Cattolica partner | GMAT expert 780/800 score | 200+ students coached

Hello Dee,

Your answer sounds good, you have basically cover all the possibilities. Just remember that there are several ways to increase your yearly cash flow, not only findind new sources of revenues.
More over, a good opportunity could be to try to spread the initial investment over several years (without paying "interests"or at least paying less than 10% per year)

Does it make sense?
Best,
Luca

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Anonymous updated the answer on Apr 10, 2020

You may also move a part of investment cost to other years, so that they are discounted and have lower effect on NPV.

(edited)

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Francesco
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replied on Apr 10, 2020
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Hi Dee,

your approach is good, as a way to increase Cash Flow I would also consider a reduction of the yearly costs of the business, besides finding extra source of revenues.

Best,
Francesco

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Clara
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replied on Apr 10, 2020
McKinsey | Awarded professor at Master in Management @ IE | MBA at MIT |+180 students coached | Integrated FIT Guide aut

Agree with the approach, and I would try to find on top ways to increase the cash flow -even if the case does not specifically ask for this-.

Cheers,

Clara

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Antonello
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replied on Apr 30, 2020
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Luca gave the best answer

Luca

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