In finance, rNPV ("risk-adjusted net present value ") or eNPV ("expected NPV") is a method to value risky future cash flows. rNPV modifies the standard NPV calculation of discounted cash flow (DCF) analysis by adjusting (multiplying) each cash flow by the estimated probability that it occurs (the estimated success rate). In the language of probability theory, the rNPV is the expected value.
Finance is a field that is concerned with the allocation (investment) of assets and liabilities over space and time, often under conditions of risk or uncertainty. Finance can also be defined as the art of money management. Participants in the market aim to price assets based on their risk level, fundamental value, and their expected rate of return. Finance can be split into three sub-categories: public finance, corporate finance and personal finance.
In finance, the net present value (NPV) or net present worth (NPW) applies to a series of cash flows occurring at different times. The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the discount rate. NPV accounts for the time value of money. It provides a method for evaluating and comparing capital projects or financial products with cash flows spread over time, as in loans, investments, payouts from insurance contracts plus many other applications.
A cash flow is a real or virtual movement of money:
rNPV is the standard valuation method in the drug development industry, where sufficient data exists to estimate success rates for all R&D phases.
Drug development is the process of bringing a new pharmaceutical drug to the market once a lead compound has been identified through the process of drug discovery. It includes preclinical research on microorganisms and animals, filing for regulatory status, such as via the United States Food and Drug Administration for an investigational new drug to initiate clinical trials on humans, and may include the step of obtaining regulatory approval with a new drug application to market the drug.
A similar technique is used in the probability model of credit default swap (CDS) valuation, but in other financial contexts, risk is incorporated by adding a risk premium percentage to the discount rate.
For an individual, a risk premium is the minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset in order to induce an individual to hold the risky asset rather than the risk-free asset. It is positive if the person is risk averse. Thus it is the minimum willingness to accept compensation for the risk.
In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted by using cost of capital to give their present values (PVs). The sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value of the cash flows in question.
The internal rate of return (IRR) is a measure of an investment’s rate of return. The term internal refers to the fact that the calculation excludes external factors, such as the risk-free rate, inflation, the cost of capital, or various financial risks.
In economics and finance, present value (PV), also known as present discounted value, is the value of an expected income stream determined as of the date of valuation. The present value is always less than or equal to the future value because money has interest-earning potential, a characteristic referred to as the time value of money, except during times of negative interest rates, when the present value will be more than the future value. Time value can be described with the simplified phrase, "A dollar today is worth more than a dollar tomorrow". Here, 'worth more' means that its value is greater. A dollar today is worth more than a dollar tomorrow because the dollar can be invested and earn a day's worth of interest, making the total accumulate to a value more than a dollar by tomorrow. Interest can be compared to rent. Just as rent is paid to a landlord by a tenant without the ownership of the asset being transferred, interest is paid to a lender by a borrower who gains access to the money for a time before paying it back. By letting the borrower have access to the money, the lender has sacrificed the exchange value of this money, and is compensated for it in the form of interest. The initial amount of the borrowed funds is less than the total amount of money paid to the lender.
Real options valuation, also often termed real options analysis, applies option valuation techniques to capital budgeting decisions. A real option itself, is the right—but not the obligation—to undertake certain business initiatives, such as deferring, abandoning, expanding, staging, or contracting a capital investment project. For example, the opportunity to invest in the expansion of a firm's factory, or alternatively to sell the factory, is a real call or put option, respectively.
In finance, valuation is the process of determining the present value (PV) of an asset. Valuations can be done on assets or on liabilities. Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation.
The APV was introduced by the italian mathematician Lorenzo Peccati, Professor at the Bocconi University. The method is to calculate the NPV of the project as if it is all-equity financed. Then the base-case NPV is adjusted for the benefits of financing. Usually, the main benefit is a tax shield resulted from tax deductibility of interest payments. Another benefit can be a subsidized borrowing at sub-market rates. The APV method is especially effective when a leveraged buyout case is considered since the company is loaded with an extreme amount of debt, so the tax shield is substantial.
Rational pricing is the assumption in financial economics that asset prices will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away". This assumption is useful in pricing fixed income securities, particularly bonds, and is fundamental to the pricing of derivative instruments.
Bond valuation is the determination of the fair price of a bond. As with any security or capital investment, the theoretical fair value of a bond is the present value of the stream of cash flows it is expected to generate. Hence, the value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate. In practice, this discount rate is often determined by reference to similar instruments, provided that such instruments exist. Various related yield-measures are then calculated for the given price.
Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to effect a sale of a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes such as in shareholders deadlock, divorce litigation and estate contest. In some cases, the court would appoint a forensic accountant as the joint expert doing the business valuation.
Capital budgeting, and investment appraisal, is the planning process used to determine whether an organization's long term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure. It is the process of allocating resources for major capital, or investment, expenditures. One of the primary goals of capital budgeting investments is to increase the value of the firm to the shareholders.
The Z-spread, ZSPRD, zero-volatility spread or yield curve spread of a mortgage-backed security (MBS) is the parallel shift or spread over the zero-coupon Treasury yield curve required for discounting a pre-determined cash flow schedule to arrive at its present market price. The Z-spread is also widely used in the credit default swap (CDS) market as a measure of credit spread that is relatively insensitive to the particulars of specific corporate or government bonds.
Valuation using discounted cash flows is a method for determining the current value of a company using future cash flows adjusted for time value of money. The future cash flow set is made up of the cash flows within the determined forecast period and a continuing value that represents the cash flow stream after the forecast period. Discounted Cash Flow valuation was used in industry as early as the 1700s or 1800s, widely discussed in financial economics in the 1960s, and became widely used in U.S. Courts in the 1980s and 1990s.
The following outline is provided as an overview of and topical guide to finance:
The Income Approach is one of three major groups of methodologies, called valuation approaches, used by appraisers. It is particularly common in commercial real estate appraisal and in business appraisal. The fundamental math is similar to the methods used for financial valuation, securities analysis, or bond pricing. However, there are some significant and important modifications when used in real estate or business valuation.
The First Chicago Method or Venture Capital Method is a business valuation approach used by venture capital and private equity investors that combines elements of both a multiples-based valuation and a discounted cash flow (DCF) valuation approach.
The fuzzy pay-off method for real option valuation is a new method for valuing real options, created in 2008. It is based on the use of fuzzy logic and fuzzy numbers for the creation of the possible pay-off distribution of a project. The structure of the method is similar to the probability theory based Datar–Mathews method for real option valuation, but the method is not based on probability theory and uses fuzzy numbers and possibility theory in framing the real option valuation problem.
Credit valuation adjustment (CVA) is the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of a counterparty’s default. In other words, CVA is the market value of counterparty credit risk. This price depends on counterparty credit spreads as well as on the market risk factors that drive derivatives’ values and, therefore, exposure. CVA is one of a family of related valuation adjustments, collectively xVA; for further context here see Financial economics #Derivative pricing.
The Datar–Mathews method is a method for real options valuation. The method provides an easy way to determine the real option value of a project simply by using the average of positive outcomes for the project. The method can be understood as an extension of the net present value (NPV) multi-scenario Monte Carlo model with an adjustment for risk aversion and economic decision-making. The method uses information that arises naturally in a standard discounted cash flow (DCF), or NPV, project financial valuation. It was created in 2000 by Professor Vinay Datar, Seattle University, and Scott H. Mathews, Technical Fellow, The Boeing Company.
Corporate finance is an area of finance that deals with sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value. Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.