What and why?
Net Present Value
is the difference in the present value of cash inflows and the present value of cash outflows of a project. Net Present Value method is one of the methods used in capital budgeting. Capital budgeting is the evaluation of projects (which require huge investments) to decide which ones to take up and which ones to discard. The net present value gives the company an idea of what value the project will add to the company if implemented.
- How to decide which project to be taken?
To decide whether to take up a certain project or not, we check its NPV. If NPV
is positive, the project should be certainly accepted. If NPV
is zero, the project may or may not be accepted taking into consideration other benefits the project will provide. If NPV
is negative certainly do not go for this project. In case you have to choose between multiple projects, choose the project with the highest positive NPV.
Suppose a project has the following associated cash flows (we are taking a small timeline of 3 years for the sake of simplicity). Cash outflows-at start of Year 1- $200, Cash inflows- at end of Year 1- $100, end of Year 2- $150, end of Year 3- $200. Suppose the rate of discount is 10%
The present value of cash outflow is $200 only because it was paid at the outset.
Present value of Cash inflow = [100/ (1+0.1)] + [150/ ((1+ 0.1) ^ 2)] + [200/ ((1+0.1) ^ 3)]
= Present value of all cash inflows – Present value of all cash outflows
= $365.12 - $200 = $165.12
This project has positive NPV
and hence should be taken up.
In case the cash inflows are of equal amount
, the calculation becomes easier, say $100 is to be received each year for 3 years in the previous example. The rest of the variables are the same.
Present Value of cash inflows = A * [1-(1+i) ^ (-n)]/i
Where A= Amount expected to be received each period (here $100)
i = rate of interest/discount rate per period (here 10%)
n= number of time periods (here 3 years)
Present value of cash inflows = 100*[1-(1+0.1)^(-3)]/0.1= $248.7
= $248.70 -$200= $48.70
- Advantages of using NPV method
- It takes into consideration – time value of money concept and hence gives a realistic picture of the project
- All cash flows during the lifetime of the project are considered for calculations.
- Risk is given priority by carefully choosing the discount rate.
- It is difficult to choose an appropriate discount rate.
- Only the profitability of the project is taken into consideration and not the size.
To extend this further, it is not possible to compare projects of different size using this method. For example, a $10000 (investment) project will most likely have a higher Net Present Value than a $1000 project even though the latter may provide more % returns and hence these cannot be compared by this method.