Need help really understanding the concept of NPV

I watched the Finance Lessons of Martin Shkreli where he said this about Net Present Value:

"The discount rate is the opportunity costs, which is equal to the risk"

He continued saying that investing in a US bond gives 1.74% return which is the amount I want to get for my default risk. And future cash can be invested in this bond right now to get the interest, resulting in a lower NPV today than future payouts. So far so good.

But what if a company has huge risk and thus extremely huge cost of equity, like 30%?
1) far lower NPV because of risk of default, makes sense
2) but how do you think about it in terms of opportunity costs??? I mean, there is no low risk investment with 30% return, still just the US GovBond at 1.74%

So how do you think about it in both forms? Or is it either the first or the second?

Comments (4)

Most Helpful
Sep 9, 2021 - 9:43am

I'm not too sure what you are exactly asking. However, a T-bill is typically the base riskless rate as the risk of the chance of default is the same risk as to the collapse of the US treasury. 

The discount rate is typically found by companies using an EV equation based on historical projects. It is very difficult to find the real discount rate of many projects in a business. The best they can do is get close, using these historical projections into the future. Many businesses have many project proposals to make money and they internally compare the discount rates of different projects and pick the ones with the highest expected return on investment.  (This is where Martin is probably referencing opportunity cost)

I think your confusion comes from the definition of the discount rate. This has multiple definitions but it sounds like you think that discount rate = bank rate. But a discount rate is any interest rate that is being used for discounting cash flows. 

Sep 9, 2021 - 9:58am

I always thought about discount rate as:

If I get 100$ in one year, what is it worth today (NPV)? Let's see, market gives me like 5% return, so it should be worth 95,238$ today. Because I can invest that to get 100$ in one year.

This however comes to an end now, because I find it very difficult to think about, e.g., DCF like that. Because you discount with the WACC, but what if you have the NPV of the cash flows. You can't really think about it as "Ok, I got this NPV, I can invest it for WACC and get XY tomorrow", can you?

And it quickly comes to an end when you e.g. want to discount cash flows to equity value and you use cost of equity as a discount rate. The company is VERY risky and you have a 30% discount rate. You can't really think of it as "I have this NPV I calculated, I can invest it for 30% to get said cash flows" because there is no market where you can score 30% interest, except for said company. 

You know what I mean?

Is it wrong how I think about that, and should I just toss these thoughts and just think about the discountrate as risk?

Sep 9, 2021 - 11:33am

I think where you have a problem in the logic is with the 30% WACC itself. It is simply so unlikely that a company will have this high of a value for WACC, which makes the exercise of finding a comparable investment unnecessary. Think of the separate elements. In terms of CAPM, this would require the beta of the investment to be absurdly high, meaning the company reacts super heavily to market fluctuations. On the other hand, it would require the company's bonds to be yielding around 30%, which means that investors have lost all faith in the company, possibly due to impending bankruptcy.

Let me know if this clarified things. Your logic seems correct for the other points. 

  • Associate 2 in PE - Other
Sep 9, 2021 - 9:59am

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