Company valuation essentially entails procedures that help in the estimation of the economic value of the company. It is comes handy in financial decisions involving mergers and acquisitions among other important business procedures. Valuation helps in determining the price that the financial market players are willing to pay or receive in the sale of an enterprise (Helfert, 2001). Company valuation is also important when it comes to settling financial disputes in relation to taxation, litigation, and share of business assets just to mention a few. Additionally, valuation is used in determining which investment decision is preferable compared to the others. Different methods of valuing companies are used some of which include NPV (Net Present Value), IRR (Internal Rate of Return) and MRR (Modified Rate of Return) (Damodaran, 1996). All these methods have common merits and demerits associated with the valuation thus, it is the duty of the management to agree on the method of valuation to be used. This paper seeks to analyze deeply the aforementioned valuation methodologies applicable in companies.
Net Present Value
The NPV method determines that actual economic value of a project by discounting cash flows after taxation. This method uses the weighted average cost of capital figures to determine how profitable a project is. Using the NPV, financial managers are able to know the actual profit level of a project when compared to other projects (Pinkasovitch, 2011, p.1). This therefore helps the managers make the right selection by choosing the most profitable project among those presented. The basic rule in capital budgeting is that only projects with a positive NPV are selected while those with negative NPV are disregarded. Actually, this method is thought to be the most accurate of all the valuation methodologies given its non-rationality.
Internal Rate of Return
The IRR is a discounting rate, which normally gives a net present value of zero. In IRR, the financial managers determine the rate of return that will be generated by different projects (Pinkasovitch, 2011, p.1). Upon computation, projects whose IRR are higher than the computed weighted average cost of capital are chosen since they are more profitable. On the other hand, an IRR value that is less than the weighted average cost of capital indicates that the project is bound to make losses. Such projects are therefore disregarded.
Below is a summary of the IRR rule:
- If IRR> Weighted cost of capital= project accepted
- If IRR< Weighted cost of capital= project rejected
Nevertheless, IRR is advantageous in decision making because it gives a benchmarking figure for different projects, which can be obtained from the capital structure of the company (Pinkasovitch, 2011, p.1).
Modified Internal Rate of Return
This method is a modification of the internal rate of return valuation methodology. The MIRR assumes that the cash flows of the company are reinvested at the cost of capital of the firm unlike in IRR where the cash flows are reinvested at the internal rate of return. Thus, MIRR is more accurate than IRR as its gives both the profitability and cost of the project.
From the above discussion, it is clear that valuation of investments is an integral part of capital budgeting. This is because a look at the project quotations does not give the actual economic value of projects thus the need for valuation (Pratt, 1998). As such, financial managers decide on the best method applicable for different projects and use them in selecting the most profitable projects.
Damodaran, A. (1996). Investment Valuation. New York: Wiley.
Helfert, E. (2001). Financial Analysis: Tools and Techniques. McGraw-Hill Professional.
Pinkasovitch, A. (2011). An Introduction to Corporate Valuation Methods. Web.
Pratt, S. (1998). Valuing Small Businesses and Professional Practices. New York: McGraw-Hill.