How do your past investments contribute in your valuation?
I was working on the valuation of a biotech product in Dec 2012. I was almost done with all the cash flows and discount rates and I was about to calculate the net present value when one of my colleagues argued that there was a mistake in the calculation of NPV.
His argument was that I had not shown the investment in that project from 2008-2011. Already 2 M Euros were invested into the development of the product that was in phase 1.So, according to him, I should take the future value of all the investments done since 2008 to 2012 and subtract those investments to get the NPV in 2012.
NPV is always forward looking. It has nothing to do with how much investment has already been done to develop a product. Consider a simple example, you invest $10 M to develop a product and you find that the product is now obsolete. A new advanced product with better technology is already launched/about to be launched in the market by your competitor.
What would be the value of your product?
Almost zero (assuming that you cannot get any cash flows in the future). In the above example, the cost is a sunk cost.
His next question was intriguing. What creates a value?
A value is always created by asset side of balance sheet. The asset is your idea that has the potential to generate cash flows. That idea is funded by Equity or Debt.
Then the interesting question is – ‘’Does the mix of Equity or Debt affect the value?’’
Stay tuned for my next VIEW post for the answer.