Net present value or NPV is a very well-known technique for analysis in the arena of finance. Net present value is equal to the present value of all the future cash flows of a project less the project’s initial outlay. It is very important and helpful in arriving at the decisions related to investment in projects, plants, or machinery.
Definition and Meaning of NPV
Net present value is the present value/today’s value of all the cashflows to be generated by an asset in the future. In other words, it is the value that can be derived using an asset. Alternatively, it is the discounted value based on some discount rate. Banks, financial institutions, investment bankers, venture capitalists, etc., are also widely used to assess an asset or even a business for arriving at its valuation.
How to Calculate Net Present Value (NPV)?
Calculation of net present value requires three things, viz. stream of future cash flows (inflows or outflows), a discounting rate, and the initial investment amount. We need to discount the future cash flows to present value using the appropriate discount rate and deduct the initial investment from the total of all the present values arrived after discounting.
The formula for Net Present Value (NPV):
|Net Present Value (NPV)
Where Cn = Cash Flow at time n.
Future Cash Flows: Future cash flows are the expected cash flow to be received by the investor on the proposed investment.
Discount Rate: It is the highest rate of return that the investor can earn by investing the same money in some other investment alternative. In other words, a discount rate is the opportunity cost of capital which means the cost of compromising the other opportunity.
Initial Investment: The initial investment is the cash outflow at the beginning of the project, like the cost of machinery, etc.
To learn more, you can refer to our article Advantages and Disadvantages of NPV.
Net Present Value (NPV) Example
Let’s understand NPV with an example. Suppose you bought machinery worth 2 Million Dollars, and it will fetch 0.5 Million Dollars every year for 6 Years, and there will be no scrap value for the machine. What should you do? Invest or Not? Apparently, somebody may say you are investing 2 million but getting 3 million, so you should go for it. Let’s say you have another opportunity to invest the same money @ 14% per annum. The following example explains that the opportunity is not worth investing in if your opportunity cost or discount rate is 14%. Cash flows are discounted by 14%, and we find that their present value is 1.94 Million. Would you enter into the deal if you are offered 1.94 Million in exchange for 2 Million today? Obviously, a rational person would not entertain that.
|Discount Factor: (1/1+14%)^n
|Present Value of Future Cash Flows
|Project Not Worth
Method and Analysis
The net present value method determines whether a project/investment is worth doing by comparing two things: initial investment and the total value of future cash flows. Net present value analysis concludes that a project is worth doing when it finds the present value of future cash flows greater than the initial investment and vice versa. It brings the complicated stream of cash flows into a simple weighing scale situation where you can easily know which is heavier. In our context, we have to see which is higher, the present value of future cash flows, or the initial investment.
Calculation of Net present value (NPV) and NPV tables
The calculation of the net present value is a little complicated due to the presence of power over the numeric values. There are pre-calculated tables of a combination of different discount rates and periods to make it simple. NPV tables are used for the sake of simplicity of calculations. Nowadays, all such applications are available in excel and are widely used. Not just a formula is available, but specific tools are also available.
Net present value has a close relation with capital budgeting. Capital budgeting requires extensive use of the NPV technique. NPV method is one of the chief methods used in capital budgeting.
We cannot deny that NPV is the best techniques for analyzing projects, but the final decision about the project cannot be made just based on this. It is always advisable to look at all the sides of the dice. There are many other metrics that are consulted, such as return on investment, profit margin, cash flows, return on assets, tax implications, different kinds of risks, etc.
Also, read How is Risk related to Net Present Value?