TABLE OF CONTENTS

The Simulation: an Introduction | Vision and Corporate Design | Decision Variables | The Contracts Program
The Market Reports | Firm Reports: Credit, Sales & Production | Firm Reports: Financial Statements
The Scent Industry | Plant and Location  | Subsidiaries | Bankruptcy | Forecasting Demand | NPV | Broker

This section offers some insight into NPV, or Net Present Value. NPV measures the ability of the firm to create wealth for the stockholder over time. NPV is employed to weigh a firm's success in relation to that of another firm. Your professor may use this measurement in determining the final results of your firm.

Stockholders are rewarded for placing their investment at risk. In this simulation, firms are start-up ventures in new markets. Such ventures have considerable risk. Over long periods of time, it would not be unrealistic for stockholders to realize a 12% annual return from proven quality stocks. Therefore, given the additional risks involved with a new management in a start-up venture, stockholders expect a return, over time, of 20% per year (set at 5% per quarter).

How is such an expectation measured? NPV is one of the best measures. But first, look at earnings from inside the corporation. Internally within the firm, it is measured by ROE or the ratio Return on Equity which is: (profit/net worth). Net worth is also referred to as stockholder's equity (see balance sheet); this identifies how much of the return on assets is getting back to the stockholders. This return can be leveraged through the use of debt in the capital structure, but in so doing, the firm is exposed to additional risks. Order and review a Special Report to see if ROE is 5% per quarter or near 20% per year.

From the stockholder's perspective ROE is important, but their return (joy or pain) is measured by stock price and dividends. Do stock prices track ROE? In general, yes, they do. But there are some other considerations. Two of the most important are discussed next.

ROE equals ROA (profit/total assets) if all the money is raised by the sale of stock and later by retaining the earnings of the firm as it prospers. This is an ultra conservatively financed firm. If the profits are paid out as dividends, and growth is facilitated by borrowing funds, ROE is propelled forward at a rate faster than ROA.

This leveraging practice is commonly used by almost all firms (that is the use of loans and bonds to fund assets). Within reason and for successful firms, it helps ROE exceed ROA and thus drives stock prices higher. For unsuccessful firms, this leverage drives the ROE downward at a rate faster than ROA. Thus, if debt/equity becomes too excessive, bankruptcy risk outweighs the enhanced ROE and stock price could decline even with great ROE statistics.

The Conclusion: stock prices track ROE as long as debt/equity is within a reasonable range.

The second consideration in relating ROE (or earnings for that matter) to stock price, is the number of shares outstanding. Given two firms, one with 1,000,000 shares and one with 250,000 shares outstanding, and also given the exact same risk level and same annual earnings, what should their relative stock prices be? The stock of the firm with only 1/4 of a million shares should be 4 times higher than the firm with a million shares. And, the stockholders should be 4 times as happy.

Don't make the hasty judgement that all firms should start out with very few shares. Starting with very few shares will restrain your opportunities for growth. Of course, that might be satisfactory for a firm planning on a market niche strategy.

Starting with very few shares limits growth potential. But, that can be overcome with an extreme debt-to-equity capital structure. If you survive and retain the earnings of the firm, the debt-to-equity ratio will moderate over time and you will have a very large company with very few shares and very high share price. That is, if you survive the early years!

What if you start with a large number of shares, you have maximum potential for growth and you're conservative? Then, as you make money, repurchase shares of stock so that in the end, you have a very large company with very few shares and very high share price.

Start with very few shares, stay relatively small, make lots of money in the upper niche(s) of the market, and your share price will be very high.

The Conclusion: stock prices track ROE as long as the number of shares outstanding are within a normal range - few outstanding shares will make a stock price volatile for any substantial movement in earnings - excessive shares outstanding will keep the stock steady and almost immoveable even given a sharp change in earnings.

Now, what about NPV? The above discussion was about earnings, risk and stock price. NPV measures the ability of the firm to create wealth for the stockholder over time. This model assumes stockholders value dividends and share price equally. It assumes stockholders expect a 5% per quarter return.

Net present value = present value (including stock and dividend value) less stockholder investment in period zero.

The average price of the stock in the last four quarters of the simulation is seen as the stock value created that can be accessed by the stockholder.

Any dividend paid by the firm is valued in the period received.

Stockholder's original investment on the day the corporation is formed equals stockholder investment at period zero. For example, let's say the stock is issued on day one of the first quarter played at $4.25

The stockholder expects that if dividends are not paid, that the stock price will increase over time at a minimum rate of 5% per quarter.

The following example shows dividends paid over 14 quarters of the simulation (second column) and share price in each of the last four quarters (third column). The last four quarters are used for share price instead of just the last quarter. This provides a level playing field across industries where earnings experience seasonal fluctuations.
 

The last column of numbers were taken from a present value discount table and relate to the period beside which they are listed. The NPV calculations are normally done on a calculator or computer. But, it is important in setting dividend policy, to visualize how time destroys the value of receiving funds. A $1 dividend received in Q1 is worth $.952 to the stockholder. If a stockholder must wait until quarter 14 to receive a $1 dividend, it is only valued at $.50.

Let's calculate ending NPV, given the information in the preceding table.

First determine the present value of the firm's stock (using the average of the last four stock prices).

(.25)($20)(.585) +

(.25)($18)(.557) +

(.25)($25)(.530) +

(.25)($26)(.500) = $11.99

($.5)(.784) +

($1 )(.746) = $1.138

Your NPV is ranked along with the NPV of all firms. Each quarter you can tell how well you are delivering for the shareholder relative to all other management teams. NPV can be a heartless taskmaster by the end of the semester.

It is important that the team understand how NPV is determined. Take the above example and do not pay dividends. Assume stock price the last four quarters are $28, $30, $30 and $36. Is NPV higher? Would it have been better to retain dividends to promote growth and thus a higher stock price?

Try the original NPV calculation but this time add dividends in period 10 of $1, along with $1 in period 11 and $1 in period 12. What is your NPV? How much was it worth to the stockholder to receive the dividends early.

Dividends are valued for themselves, but they also can influence stock price in a positive direction if declared in a financially prudent manner. Thus, dividend policy for a mature firm with limited growth opportunities needs to be addressed.

Remember that your firm is restricted to a $.50 dividend increase per quarter.

1. Don't assume that dividends are the most desirable way to enhance share price. Any time the firm can retain earnings and invest those earnings to generate a return of 5% or more per quarter in the future, it should do so.

Successfully employing retained earnings will eventually push the stock price higher and thus the NPV will be higher than if the firm had paid dividends. Some of the highest NPV firms never pay dividends.

2. Don't get caught in a short term NPV contest. It is the last four quarters that count most. Long run strategies take time to play out. Stock prices in the short run are not even considered in the NPV model.

3. Don't simply invest in your firm if you find yourself with cash. Even if you can make a good return (say 18% annually), NPV will gradually fall if the return is not at least 5% per quarter (about 20% per year). Use the extra cash for dividends or a stock repurchase plan instead of plant expansion.