What is Net Present Value?
Net present value is the difference between present value of cash inflows and present value of cash outflows. It is a technique used to evaluate potential investment decisions. Decisions could be for an investment in or replacement of a fixed asset, investment or acquisition of a Company or Investment in a Capital-intensive project or Research and development project.
Net Present value is used more often compared to other methods (like, pay-back period, average rate of return etc.) for evaluating projects. This is because it takes into consideration the time value of money.
Time value of money means that cash flows received today are worth more than cash flows to be received in the future. This is because of inflation and other investment opportunities which the investor may have.
For example, if you have the option of receiving $10,000 today or after 1 year. You should opt out for receiving it today. You have the option to receive it today and invest it in bank deposits. The same $10,000 can become $10,500 after one year (assuming 5% interest rate). Therefore, $10,000 today is $10,500 after one year. This is why cash flows received today are worth more than the cash flows to be received in the future.
Why is Project evaluation important?
Evaluating project viability is the most important responsibility of a Finance manager. This is due to several reasons.
- It often involves significant investment long-term assets with long lives. Therefore, it is important to make the right decision for the success of the business.
- Access alignment with long term strategic priorities of the company.
- Identify the best investment opportunity when there are multiple available opportunities and capital constraint.
- Making a good investment decision is consistent with managements primary goal of maximizing shareholder value.
Net Present value is the most effective and useful technique to help evaluate the project viabilityand make strategic and financial decisions, which would help in creating value for shareholders.
Projects with positive NPV are considered value creating while those with negative NPV are value destroying for shareholders.
How is NPV Calculated?
Net present value is calculated as the Present value of cash inflows minus present value of cash outflows.
The formula to calculate the Net Present value is:
Net present value = n∑t=1Ct / (1+r)t – C0
Where, Ct = cash inflow at the end of year t
n= life of the project
r= discount rate or the cost of capital
Co= cash outflow
Accept – Reject Criteria:
If the NPV is positive, the project is accepted.
If the NPV is negative, the project is rejected.
If the NPV is NIL, then the acceptance or rejection of the project does not impact the shareholder value.
Let us understand this with the help of a simple example.
ABC is considering investment of $100,000 in a manufacturing facility. The project is expected to generate cash flows for 5 years as follows.
At the end of the 5th year the manufacturing facility can be sold off for $15,000/-. Cost of capital is 10%. You are asked to evaluate the project.
NPV = PV of cash inflows (-) PV of cash outflows.
This project has cash outflow of $100,000/- at the start of the project (Year 0). Since it is at the Year 0 therefore PV of cash outflows is equal to $100,000 in this case.
For cash inflows, you will have to discount the cash flows to present value. This can be done with the help of a simple formula.
Net Present Value for the project is positive ($2,577). Therefore, it can be accepted as it is value creating for shareholders.
Merits of Net Present Value
- It takes into consideration the Time Value of Money. As discussed above, Cash flows received today are worth more than cash flows to be received in the future.
- It measures the profitability of the project by considering the cash flows throughout the projects lifetime.
- It is consistent with the managements objective of maximizing the returns to shareholders.
Demerits of Net Present Value
- The forecasting of cash flows is difficult because of several uncertainties.·
- It is difficult to compute the discount rate precisely. This is one of the crucial factors in the computation of the NPV. Change in the discount rate results in change in NPV and may also result in change in the business decision.
- Another demerit of NPV is that it is an absolute measure, it accepts or rejects the projects only on the basis of its higher value irrespective of the cost of initial outlay.
NPV is an effective measure for making investment decisions. To compute the Net Present value, a firm should determine the cash inflows and the outflows along with the discount rate or a rate of return that firm desires during the lifetime of the project. However, in certain circumstances NPV may not be a conclusive measure. The firm should also consider the riskiness or limitation of forecasting future cash flows, availability of capital, external environment etc. before making the investment decision.
To become an expert in financial analysis and modeling techniques, you need to master the skills through Financial Analyst courses.
Good luck, keep learning!!
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