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# Net Present Value (NPV) Analysis of Fremont Petroleum Corporation Limited

Posted by Sabrina Warren on Aug-26-2021

Here at EssayPandas, we provide expert help to students of finance degree programs. We assist them in completion of different assessment, theoretical frameworks, calculations and subject-specific case studies, i.e., NPV Analysis of Fremont Petroleum Corporation Limited covering the subject of Finance, also touching upon manufacturing, Mergers, & Acquisitions. For instance, (NPV), the net present value of an investment proposal is the present value of the proposal's net cash flows less the proposal's initial cash outflow.

NPV analysis shows whether a certain project is
profitable or not and whether it is worth your investment consideration. If the
net present value of a project is positive, then it is worth pursuing as it
creates value for the money. The management at Fremont Petroleum Corporation Limited is keen to find out the net present value of
the company to make more informed and right decisions. Here below is a detailed
demo of the Net Present Value calculations. Seek professional help for your custom NPV Analysis of Fremont Petroleum Corporation Limited.

## Overview of NPV Analysis

Within the ambit of finance, there are several tools and techniques being deployed by various people including competitive intelligence professionals to interpret and analyze the financial health of a company and its contemporaries. Be it Fremont Petroleum Corporation Limited considering the option of mergers and acquisitions (M&A) or valuing a project to proceed further with it or not, NPV analysis serves as one of the simplest tools available (Dikov, 2020).

NPV is a tool used to measure profitability; it is utilized to calculate the current value of cash flows an investment will be able to produce for the Fremont Petroleum Corporation Limited (AccountingTools, 2021). Simply put, NPV can be stated as the present value of cash inflows less the present value of cash outflows. NPV is commonly used for budgeting, where the company is keen on selecting the project/investment with the highest NPV (cleartax, 2021).

## Introduction of Model

While we are making use of NPV as a technique to obtain the current values of cash flows projected in the future, we need to understand that NPV analysis is most effective when comparing similar investment alternatives as only then can the Fremont Petroleum Corporation Limited compare more than one project on different parameters (FERNANDO, 2021). Moreover, NPV relies heavily on the discount factor that is actually the interest rate required to proceed ahead with the proposed project/investment (lumen, 2021). The key point to note here is that NPV calculations involve assumptions being made for future events which may or may not happen in reality thus this can be a major flaw of this tool.

## Methodology

To further make things simpler to understand, Fremont Petroleum Corporation Limited hopes to first identify the different interpretations of NPV and then delve deeper into the application of the model. The NPV model is representative of what value the company’s investment holds today on a discounted cash flow basis. This in turn determines whether the project/investment is viable enough to be proceeded further with or not. If NPV turns out positive, the investment becomes worth taking because it essentially means the company receiving a cash payment equivalent to NPV (JOHNSON, 2003). On the other hand, if the NPV turns out negative, proceeding further with the investment will dilute Fremont Petroleum Corporation Limited’s value and should be rejected.

## Application of Model

Before we delve directly into NPV calculation, we need to first discuss how to arrive at an appropriate discount rate.

### Discount Rate

According to the concept of the Time value of money (TVM), money now holds more worth than the same money in the future. To account for this decrease in the value of money, there is a need to use a discount factor in calculating the Net present value. In order to consider the concept of TVM as well as to accommodate any risks associated with the investment opportunity, discounted cash flows are calculated (SCHMIDT, 2014). Accounting for these inherent risks is equally as important as it is to consider TVM as there are different risk levels attached with different prospects. Therefore, the discount rates applied in Fremont Petroleum Corporation Limited receiving cash flows through government bonds will certainly have a lower discount rate applied as compared to a fintech startup where there are several inherent risks involved (CAMPBELL, 2019).

### Options for Discount Rate

One option for the discount rate is considering the return expected on projects of indifferent risk exposure. Still, a better approach would be to use the Fremont Petroleum Corporation Limited’s specific discount rate as that is more reflective of how the company receives its funding. It can be WACC as it is the rate used by Fremont Petroleum Corporation Limited to finance its other projects. Moreover, the interest rate that is expected to be generated if the funds are invested elsewhere can be used. If other options do not work and limited funds are available, then the rate used for reinvestment can help calculate the potential loss if the said investment opportunity is not pursued any further (Wrike, 2021).

The choice of using the discount rate for NPV calculation can be extremely critical to the end results therefore proper attention needs to be paid to determining the most appropriate discount rate. Although there are multiple ways of arriving at a discount rate, Fremont Petroleum Corporation Limited should focus on using the discount rate that best matches the way it is being financed. For the purpose of our analysis, we will make use of WACC as the discount rate for our NPV analysis (CFI, 2021).

## Weighted Average Cost of Capital (WACC)

### Overview

We can calculate WACC if Fremont Petroleum Corporation Limited has both equity and debt components of financing. For WACC, it is necessary to have the market values of debt and equity, the effective rate on debt, the effective rate on equity, and the company’s corporate tax rate. The following table shows an example of WACC calculation for Fremont Petroleum Corporation Limited:

Market Value (Millions) | Weight | Cost of Capital | WACC | |
---|---|---|---|---|

Financing | ||||

Debt | 250 | 25% | 8% | 2.11% |

Equity | 750 | 75% | 16% | 12.00% |

Total | 1000 | 100% | 14.11% | |

Corporate Tax Rate | 35% | |||

Rd | 13% | |||

Re | 16% |

### Calculation and Explanation

As shown in the table above, Firm Fremont Petroleum Corporation Limited is being financed 75% by equity and 25% by debt. The corresponding market values for debt and equity have been provided. The effective rate on equity is 16%, the effective rate on debt is 13%, and the tax rate is 35%. The after-tax rate on debt is calculated which turns out to be 8%. Once all values have been gathered, the value for WACC is determined which is 14.11%. This is basically the discount factor applied for calculating the NPV in later sections. This is one aspect of moving ahead but will it vary depending on the proportion of debt and equity component if Fremont Petroleum Corporation Limited restructures its financing.

## Net Present Value Calculation

### Overview

The NPV is determined by adding the cash flows which are discounted minus the cost incurred for undertaking the project. We hope to understand it further using the example illustrated below.

Cash Inflows | 15,000,000 | 20,000,000 | 27,500,000 | |
---|---|---|---|---|

Year | 0 | 1 | 2 | 3 |

Cash Outflows | (50,000,000) | |||

Discounted Cash Flows | (50,000,000) | 13,636,364 | 16,528,926 | 20,661,157 |

Net Present Value (NPV) | 826,446 | |||

Discount Rate (I) | 10% |

### Calculation and Explanation

As shown in the table above, Firm Fremont Petroleum Corporation Limited is looking for a fruitful investment opportunity and thus looks forward to acquiring Firm D. The cost of acquiring is stated at 50 million while Firm Fremont Petroleum Corporation Limited expects Firm D to generate cash outflows of 15 million, 20 million, and 27.5 million in year 1, 2, and 3. The discount rate applied, in this case, is 10% which is used to calculate the discounted cash flows for years 1, 2, and 3. Consequently, NPV is calculated which turns out positive (826,446). The expected cash flow is simply divided by [(1+ (discount rate) ^ time period]. To showcase an example, in year 1, 15 million is divided by [(1+10%) ^1] to get the value 13,636,364.

## NPV Scenario 1 – Mergers & Acquisitions

### Overview

NPV analysis is most easily used while doing it for a possible merger and acquisition scenario as there are some inherent difficulties in projecting cash flows in a project scenario. For mergers and acquisitions, the company needs to just know the existing market standing of the firm being acquired and the existing market standing of the acquirer along with any synergies that are expected to come along as a result of the merger (Jelies, 2021). To illustrate an example, let’s consider Firm Fremont Petroleum Corporation Limited’s value to be 500 million and Firm D’s value to be 300 million with some additional information that both firms are completely equity-financed. Some market analysis is done, and it turns out that the market believes that the combined firm is expected to have a market value of 950 million which is indicative of the fact that there is synergy between the two firms of 150 million. As a result, Firm D will only proceed with a merger if Firm Fremont Petroleum Corporation Limited provides them 275 million in cash or pay a premium of 75 million to its current market value. Therefore, the NPV value for this merger and acquisition scenario would be 75 million (CARLSON, 2021).

### Key Takeaway

One key learning from this example is that the synergy between the two companies is extremely important. The value of synergy is basically adding all discounted cash flows expected in the future from activities like increasing revenue, cost-cutting, and lowering the tax burden.

## NPV Scenario 2 – Project Valuation Scenario

### Overview

After having discussed the scenario of merger and acquisition, it seems suitable to discuss the use of NPV in project valuation scenarios. This analysis can be further subdivided into two examples. One is where the existing machinery is being updated while in the other one, the new machine is being bought. Both of these project valuation scenarios are extremely relevant in day-to-day business operations. When Fremont Petroleum Corporation Limited commits to a project, it usually has more than one option to choose from. While some projects are exact alternatives to one another, some can be considered as mutually exclusive to one another. In these scenarios, NPV analysis becomes crucial to help a firm to decide which project to proceed further with given a set of CAPEX (capital expenditure) budgets (ACCOUNTING FORMANAGEMENT.ORG, 2021). We first consider an example where there is a need to update an existing machine.

Upgrading Existing Machine | ||||
---|---|---|---|---|

Year | 0 | 1 | 2 | 3 |

Cost: | (1,000,000) | |||

Expected Flows - Revenue Increase | 275000 | 350000 | 425000 | |

Expected Flows - Cost Reduction | 100000 | 100000 | 100000 | |

Total Expected Cash Flows | (1,000,000) | 375000 | 450000 | 525000 |

Discounted Flows | (1,000,000) | 328623.07 | 345577.99 | 353313.02 |

NPV | 27,514 |

### Calculation and Explanation

As shown in the table, Firm Fremont Petroleum Corporation Limited is looking to update the existing machine and for which they have to incur the cost of 1 million initially. While the expected cost reduction because of the updated existing machine is 100,000 for years 1,2, and 3, there is also an expected increase in revenue of 275,000, 350,000, and 425,000 in years 1,2, and 3. The discount factor used is WACC which was calculated initially which was 14.11%. Then, the discounted cash flows for years 1,2, and 3 are calculated simply by dividing total expected cash flows by [(1+discount rate) ^time period]. For example, for year 1, 375,000 is divided by [(1+14.11%) ^1] to calculate discounted cash flow of 328,623.07. Consequently, the NPV is calculated as 27,514 which is positive and gives an indication towards proceeding further with the idea of updating the existing project (Gallo, 2014).

### Overview

In the second scenario, we hope to analyze the case where a new machine needs to be bought.

Year | 0 | 1 | 2 | 3 |
---|---|---|---|---|

Cost: | (2,000,000) | |||

Expected Flows - Revenue Increase | 500000 | 625000 | 750000 | |

Expected Flows - Cost Reduction | 125000 | 125000 | 125000 | |

After-Tax Salvage Value - Old Machine | 132,000 | |||

Total Expected Cash Flows | (1,868,000) | 625000 | 750000 | 875000 |

Discounted Flows | (1,868,000) | 547705.12 | 575963.32 | 588855.03 |

NPV | (155,477) |

### Calculation and Explanation

As shown in the table, Firm Fremont Petroleum Corporation Limited is looking to purchase a new machine and for which they have to incur the cost of 2 million initially. While the expected cost reduction because of purchasing a new machine is 125,000 for years 1,2, and 3, there is also an expected increase in revenue of 500,000, 625,000, and 750,000 in years 1,2, and 3. Additionally, the old machine is disposed of, and the after-tax salvage is calculated as 132,000. The discount factor applied is WACC which was calculated initially which was 14.11%. Then. the discounted cash flows for years 1,2, and 3 are calculated by dividing total expected cash flows by [(1+discount rate) ^time period]. For example, for year 2, 750,000 is divided by [(1+14.11%) ^1] to calculate the discounted cash flow of 575,963.32. Consequently, the NPV calculated is -155,477 which is negative and gives a signal towards not proceeding forward with the said idea of purchasing a new machine. If we were to compare the two projects stated above, wherein one case you can update the existing machine and in the other case, you can purchase a new machine. According to our analysis, the NPV for upgrading current equipment is positive and is a better choice for Firm Fremont Petroleum Corporation Limited given its CAPEX budget (Accounting Coach, 2021).

## NPV Scenario 3 – Valuing Businesses

### Overview

One more scenario where NPV is frequently used is to value the business. Firstly, a discounted cash flow (DCF) model is created incorporating all income and expenses; major costs, changes in the cash conversion cycle, and any assumptions made while creating the model. Normally, a five-year projection is made for the statement of profit or loss, statement of financial position, and statement of cash flow. This will help calculate free cash flow (FCF) and in turn the terminal value that will be more useful after five years. Lastly, the cash inflows fewer cash outflows are then discounted using the Fremont Petroleum Corporation Limited’s WACC for determining the estimated value of the business today (BREAKING INTO WALL STREET, 2021).

Year | 1 | 2 | 3 |
---|---|---|---|

Free Cash Flows | -9924816.269 | -4669272.606 | 2826374.54 |

Terminal Value | -186860333.9 | -87911132.51 | 53213810.3 |

Present Terminal Value | -162487246.9 | -66473446.13 | 34988944.06 |

Present Value of Free Cash Flows | -8630275.017 | -3530640.912 | 1858387.139 |

PV of all FCF | 24686415.27 | ||

Initial Cost | 8313996 | ||

Enterprise Value | 16372419.27 |

Assumptions | |
---|---|

WACC | 15% |

Growth Rate | 9% |

### Calculation and Explanation

As shown in the table, this is an illustration of the valuation method stated above. As free cash flows have been calculated for Firm Fremont Petroleum Corporation Limited, similar methods are used to calculate the terminal value and eventually the enterprise value (Skok, 2021). We can then further use the enterprise value to calculate the return on investment to further strengthen our analysis. In the entire process, the NPV analysis seems beneficial as seen in calculating the present values of free cash flows and terminal value.

## NPV Profiles

### Interpreting the NPV Profile

We can further enhance our analysis by drawing graphs like the one drawn above to understand the relationship between NPV and discount rate better. While the discount rate is the independent variable, NPV is the dependent variable. Usually, there is an inverse relationship observed between NPV and discount rate so that helps interpret and analyze better (Thakur, 2021). However, one key drawback of the NPV profile is that cash flows are assumed to be discounted at the same rate (ANALYST PREP, 2021).

### Analyzing the graph

The special discount rate illustrated is the internal rate of return (IRR) where NPV equals zero thus meaning cash inflows equal the cash outflows. The NPV profile is also one important part of the overall NPV analysis to make things simpler to analyze and facilitate the analysts in studying the said project/investment better (XPLAIND, 2021).

## Applicability

To commemorate, Net present value (NPV) can be considered as an intrinsic valuation which is used majorly for financial analysis to calculate the current financial value of the company, any opportunities to invest in, new initiatives, and plans to cut down costs. Fortunately, this technique is being used anywhere where there are future cash flows involved. The NPV calculation provides the company with the presented cash flows which are discounted minus the outflows of cash in earlier periods as well as any additional expenditure expected to be incurred over the course of the intended project/investment.

## Conclusion

NPV analysis is indeed an effective technique for financial analysis and financial modeling but there are certain drawbacks of this technique that need to be accounted for while making use of it. There are chances of omission in the initial costs due to some issues while planning the project. For NPV, Fremont Petroleum Corporation Limited continues to use the same discount factor for the entire project despite knowing that in the practical world it cannot avoid changes in rate. Moreover, it might make some errors in calculating the future cash flows or incur some unexpected expenditures. All these changes might make the option of using NPV analysis a little questionable. Therefore, it is suggested to do a sensitivity analysis as an additional check to ensure that a robust NPV analysis is in a place free from any sort of manipulation to achieve desired results.

## References

1. Accounting Coach. (2021, 08 08). Do I buy a new machine or use an old one? Retrieved from Accounting Coach: https://www.accountingcoach.com/blog/buy-machine-replace-present-value

2. ACCOUNTING FORMANAGEMENT.ORG. (2021, 07 15). Net present value method. Retrieved from ACCOUNTING FORMANAGEMENT.ORG: https://www.accountingformanagement.org/net-present-value-method/

3. AccountingTools. (2021, 04 17). Net present value analysis. Retrieved from AccountingTools: https://www.accountingtools.com/articles/2017/5/17/net-present-value-analysis

4. ANALYST PREP. (2021, 06 15). NPV Profile. Retrieved from ANALYST PREP: https://analystprep.com/cfa-level-1-exam/corporate-finance/npv-profile/

5. BREAKING INTO WALL STREET. (2021, 08 15). How to Calculate the Discount Rate in a DCF. Retrieved from BREAKING INTO WALL STREET: https://breakingintowallstreet.com/biws/how-to-calculate-discount-rate/

6. CAMPBELL, P. (2019, 08 16). Discount Rate Formula: Calculating Discount Rate [WACC/APV]. Retrieved from RECUR: https://www.profitwell.com/recur/all/discount-rate-formula

7. CARLSON, R. (2021, 02 09). Net Present Value (NPV) as a Capital Budgeting Method. Retrieved from the balance: https://www.thebalancesmb.com/net-present-value-npv-as-a-capital-budgeting-method-392915

8. CFI. (2021, 06 26). Net Present Value (NPV). Retrieved from CFI: https://corporatefinanceinstitute.com/resources/knowledge/valuation/net-present-value-npv/

9. cleartax. (2021, 05 11). NPV ( Net Present Value ) – Formula, Meaning & Calculator. Retrieved from cleartax: https://cleartax.in/s/npv-net-present-value

10. Dikov, D. (2020, 03 16). Using the Net Present Value (NPV) in Financial Analysis. Retrieved from MagniMetrics: https://medium.com/magnimetrics/using-the-net-present-value-npv-in-financial-analysis-68bfe71bc2

11. FERNANDO, J. (2021, 04 09). Net Present Value (NPV). Retrieved from Investopedia: https://www.investopedia.com/terms/n/npv.asp

12. Gallo, A. (2014, 11 19). A Refresher on Net Present Value. Retrieved from Harvard Business Review: https://hbr.org/2014/11/a-refresher-on-net-present-value

13. Jelies, I. (2021, 01 12). How to calculate synergies in M&A. Retrieved from ALPHA GAMMA: https://www.alphagamma.eu/finance/how-to-calculate-synergies-in-ma/

14. JOHNSON, D. (2003). NPV ANALYSIS AND APPLICATIONS FOR. Competitive Intelligence Magazine, 3.

15. lumen. (2021, 05 14). Net Present Value. Retrieved from lumen: https://courses.lumenlearning.com/boundless-finance/chapter/net-present-value/

16. SCHMIDT, R. (2014, 09 02). What You Should Know About the Discount Rate. Retrieved from PropertyMetrics: https://propertymetrics.com/blog/npv-discount-rate/

17. Skok, D. (2021, 04 17). How to calculate the Discount Rate to use in a Discounted Cash Flow (DCF) Analysis. Retrieved from forEntrepreneurs: https://www.forentrepreneurs.com/discount-rate-for-dcf/

18. Thakur, M. (2021, 07 15). NPV Profile. Retrieved from WallStreetMojo: https://www.wallstreetmojo.com/npv-profile/

19. Wrike. (2021, 07 26). What is Net Present Value (NPV) in Project Management? Retrieved from Wrike: https://www.wrike.com/project-management-guide/faq/what-is-net-present-value-npv-in-project-management/

20. XPLAIND. (2021, 05 20). NPV Profile. Retrieved from XPLAIND: https://xplaind.com/121973/npv-profile

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