Net Present Value (NPV)
Net present value, npv, is a capital budgeting formula that calculates the difference between the present value of the
Net Present Value (NPV)
Net Present Value, NPV, Is A Capital Budgeting Formula That Calculates The Difference Between The Present Value Of The Cash Inflows And Outflows Of A Project Or Potential Investment.
It’s Used To Evaluate The Amount Of Money That An Investment Will Generate Compared With The Cost Adjusted For The Time Value Of Money.
This Is An Important Concept Because It Demonstrates The Money Isn’t Free And One Rupee Today Is Always Worth More Than One Rupee Tomorrow. The Reason For This Is Simple: Interest And Opportunity Costs. It Costs Money To Borrow Money. Thus, The Interest Rate Devaluates Future Cash. Opportunities Costs Are Not Tangible Expenses, But They Do Affect How Money Is Invested.
NPV Is Used In Capital Budgeting And Investment Planning To Analyze The Profitability Of A Projected Investment Or Project.
The NPV Formula Is Somewhat Complicated Because It Adds Up All Of The Future Cash Flows From An Investment, Discounts Them By The Discount Rate, And Subtracts The Initial Investment.
NPV Formula Components
Here’s What Each Symbol Means:
Ct = Net Cash Inflow For The Period
CO = Initial Investment
R = Discount Rate
T = Number Of Periods
Another Way To Calculate NPV:
As You Can See, The Net Present Value Formula Is Calculated By Subtracting The PV Of The Initial Investment From The PV Of The Money That The Investment Will Make In The Future. This Discounts The Future Dollars That Will Be Generated Over The Course Of The Investment’s Life With The Current Dollars That It Costs To Purchase The Investment, So Investors Can Compare The Potential Return From The Investment With Its Initial Cost.
Why Is Net Present Value (NPV) Analysis Used?
NPV Analysis Is Used To Help Determine How Much An Investment, Project, Or Any Series Of Cash Flows Is Worth. It Is An All-Encompassing Metric, As It Takes Into Account All Revenues, Expenses, And Capital Costs Associated With An Investment In Its Free Cash Flow (FCF).
In Addition To Factoring All Revenues And Costs, It Also Takes Into The Account The Timing Of Each Cash Flow That Can Result In A Large Impact On The Present Value An Investment. For Example, It’s Better To Have Cash Inflows Sooner And Cash Outflows Later, As Opposed To The Opposite Of That.
- You need to follow selection criteria with regards to the usage of NPV. Calculation of NPV will result in three possible outcomes:
- Positive NPV: In this situation, the present value of cash inflows is greater than the present value of cash outflows. This is an ideal situation for investment
- Negative NPV: In this situation, the present value of cash inflows is less than the present value of cash outflows. This is not an ideal situation and any project with this NPV should not be accepted.
- Zero NPV: In this situation, the present value of cash inflows equals the present value of cash outflows. You may or may not accept the project.
What NPV Doesn’t Tell Me?
NPV Is A Frequently Used Tool In The Field Of Finance. But NPV Doesn’t Tell You Everything That You Need To Know
It Suffers From The Following Limitations:
- NPV is based on a lot of assumptions and estimates. If any of the assumptions are wrong, the entire exercise of valuations will be rendered futile.
- NPV doesn’t take into account risks inherent in an investment. This may lead to overestimation of the cash flows which can mislead the investors.
- NPV ignores the possibilities of any escalations in the project cost in future. Sudden unforeseen expenditure may dis-balance the entire projections
Use In Decision Making
NPV Is An Indicator Of How Much Value An Investment Or Project Adds To The Firm. With A Particular Project,
Appropriately Risked Projects With A Positive NPV Could Be Accepted. This Does Not Necessarily Mean That They Should Be Undertaken Since NPV At The Cost Of Capital May Not Account For Opportunity Cost, I.E., Comparison With Other Available Investments. In Financial Theory, If There Is A Choice Between Two Mutually Exclusive Alternatives, The One Yielding The Higher NPV Should Be Selected.
A Positive Net Present Value Indicates That The Projected Earnings Generated By A Project Or Investment (In Present Dollars) Exceeds The Anticipated Costs (Also In Present Dollars). Generally, An Investment With A Positive NPV Will Be A Profitable One And One With A Negative NPV Will Result In A Net Loss. This Concept Is The Basis For The Net Present Value Rule, Which Dictates That The Only Investments That Should Be Made Are Those With Positive NPV Values
|NPV > 0||the investment would add value to the firm||the project may be accepted|
|NPV < 0||the investment would subtract value from the firm||the project may be rejected|
|NPV = 0||the investment would neither gain nor lose value for the firm||We should be indifferent in the decision whether to accept or reject the project. This project adds no monetary value. Decision should be based on other criteria, e.g., strategic positioning or other factors not explicitly included in the calculation.|
An Alternative Way Of Looking At Net Present Value Is That At The Given Rate Of Cost Of Capital, Whether The Project Can Meet The Cost Of Capital. For Example, If The NPV Is Rs -2.5crore (I.E. Negative NPV) For A Given Project, It May Mean That At The Given Weighted Average Cost Of Capital (WACC), The Project Fails To Meet The Expectations Of The Suppliers Of Capital For The Project.
On The Other Hand, The NPV Of Rs 2.5 Cr Would Add Rs 2.5cr To The Wealth Of The Suppliers Of Funds Over And Above Their Expected Returns.
Conflict Between NPV And IRR
When You Are Analyzing A Single Conventional Project, Both NPV And IRR Will Provide You The Same Indicator About Whether To Accept The Project Or Not. However, When Comparing Two Projects, The NPV And IRR May Provide Conflicting Results. It May Be So That One Project Has Higher NPV While The Other Has A Higher IRR. This Difference Could Occur Because Of The Different Cash Flow Patterns In The Two Projects.
The Following Example Illustrates This Point.
Project A Project B
Year 0 -5000 -5000
Year 1 2000 0
Year 2 2000 0
Year 3 2000 0
Year 4 2000 0
Year 5 2000 15000
NPV 2,581.57 4,313.82
IRR 29% 25%
The Above Example Assumes A Discount Rate Of 10%. As You Can See, Project A Has Higher IRR, While Project B Has Higher NPV.
If These Two Projects Were Independent, It Wouldn’t Matter Much Because The Firm Can Accept Both The Projects. However, In Case Of Mutually Exclusive Projects, The Firm Needs To Decide One Of The Two Projects To Invest In.
When Facing Such A Situation, The Project With A Higher NPV Should Be
Chosen Because There Is An Inherent Reinvestment Assumption. In Our Calculation, There Is An Assumption That The Cash Flows Will Be Reinvested At The Same Discount Rate At Which They Are Discounted.
In The NPV Calculation, The Implicit Assumption For Reinvestment Rate Is 10%. In IRR, The Implicit Reinvestment Rate Assumption Is Of 29% Or 25%. The Reinvestment Rate Of 29% Or 25% In IRR Is Quite Unrealistic Compared To NPV. This Makes The NPV Results Superior To The IRR Results. In This Example, Project B Should Be Chosen.