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Companies and businesses use different tools in their capital budgeting and investment appraisal process. Some of these tools are simpler, while others require complex calculations based on the time value of money concept. One such tool that is most commonly used by businesses is Net Present Value (NPV).
What is Net Present Value?
Net Present Value (NPV) is a method used in investment appraisal to calculate the present value of all the future cash flows of a project, including its initial capital investment. In other words, NPV calculates the present value of the cash flows of a project by deducting all its cash inflows from its outflows. The name also suggests that it is the net of all the present values of cash inflows and outflows of a project.
How to calculate Net Present Value?
Calculating the NPV of a project often requires complex calculations and takes into account several factors. However, the following formula can help in the determination of NPV in its simplest form.
NPV = Cash flows / (1 + r)n – Initial capital investment
First of all, the above formula only assumes fixed annual cash flows. If the cash flows from a project are not constant, it doesn’t work. ‘r’ in the above formula represents the required rate of return or discount rate. ‘n’, on the other hand, signifies the number of periods for which the project will run.
How to make decisions based on Net Present Value?
One of the reasons why NPV is a commonly used model is because of its straightforward decision-making rules. When making decisions based on NPV, businesses have to determine whether the NPV of a project is positive or negative. A positive NPV means that the project will generate more inflows as compared to its outflows and, therefore, is viable for the business.
On the other hand, a negative NPV means the outflows caused by a project exceed its inflows. Thus, the project will end up generating a loss for the business that is taking up the project. Therefore, any project with a negative NPV is not viable.
Example
A company, Green Co., wants to start a new project. Initially, the company will have to invest $100,000 in capital into the project. Eventually, the project will start generating cash inflows of $30,000 for the next 6 years. Green Co.’s required rate of return is 10%. Therefore, the project’s net present value will be as follows.
NPV = Cash flows / (1 + r)n – Initial capital investment
NPV = ($30,000 x 6) / (1 + 10%)6 – $100,000
NPV = $101,580 – $100,000
NPV = $1,580
In this case, the NPV of the project for Green Co. is positive as the cash inflows ($101,580) exceed the initial capital investment required for the project ($100,000). Therefore, Green Co. must take the project as it will result in a profit in the future.
Conclusion
Net Present Value is a commonly used investment appraisal tool. The NPV of a project represents the net value of the present value of its cash inflows and outflows. If the NPV of a project is positive, it means the project will make a profit and, therefore, is viable. On the other hand, a negative NPV represents a loss-making project.
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