At some point in time, every business has to make a decision on whether to invest in that machine, technology, land, or even a project. This is challenging because it directly impacts the business’s profit viability. The project or asset would surely bring cash flow in the future, but what is the present value of that cash flow–this has to be determined. The formula of Net Present Value or NPV is the solution here to identify the present value of the project or investments.
In this article, we will discuss Net Present Value, its formula, its drawbacks, how to calculate it, what the different value of NPV means, and why it is crucial for a business.
What is Net Present Value?
Net Present Value is the discounted present value of all the future cash flows of investment in a capital project, real estate, or a new venture. We can call it a difference between the future and the present value of cash flows. This capital budgeting method helps a company identify the best profitable project based on its cash flow.
Companies can use NPV to compare the similar type of investment options. It also includes the interest rate or the discount rate of the project to make a comprehensive calculation.
Net Present Value has the principle of Time Value of Money at the core. This refers to the fact that with time inflation rusts investments, and the value of money will change and reduce in the future. For example, today’s Rs. 1000 would be worth Rs. 950 after five years. Thus, it is important for a company to discount the future value at a rate that can help it know how much the project is valued in the present.
The future value must be higher at an equal to or more than the discount rate for the project to be viable at present. There are other cost budgeting methods used in corporate finance including Average Rate of Return and Payback Period. However, NPV is used widely.
How to Calculate Net Present Value?
You can calculate NPV using the following formula.
When there is only a single cash flow entry
Net Present Value = Cash flow / (1+i)t – Initial Investment Amount
Where;
i = Discount rate or required rate of return
t= Number of periods
If there are multiple cash flows during a period
Net Present Value = (Z1 / 1+r) + (Z2 / 1+r)2 + …. – X0
Where;
Z= Cash flow
r= Required rate of return
X0 = Initial investment
It can also be written as = ∑ Rt / (1 + r)t
Whereas Rt= Net cash inflows deducted by net cash outflows at the time t
Using these formulas, a company can find the net present value of cash flows by using a specific discounted rate. The conclusion of this formula helps in deciding whether to invest in a capital-intensive project or not.
Defining the Value of NPV
There can be three values of NPV.
- If it is 0 = No difference in inflows and outflows or taking up the project.
- If it is 0+ = The cash inflow is more than the outflow, and the project will drive positive values for the business.
- If it is -0 = The cash outflow is more than the inflow, and this project is not a feasible investment decision.
Understanding NPV with an Example
Let’s understand NPV with an example to understand it better. Company A wants to expand its current operations by investing in Project X1. The future cash flows of this project during its 5-year tenure would be Rs. 50,000 for the first 4 years and Rs. 8,00,000 at the end of the 5th year. The discount rate is 6%. What would be this project’s present value if Company A takes it up at an initial cost of Rs.3,00,000?
NPV = (Z1 / 1+r) + (Z2 / 1+r)2 + …. – X0
= [Rs, 50,000 / (1 + 0.06)] + [50,000 / (1 + 0.06)2] + [50,000 / (1 + 0.06)3] + [50,000 / (1 + 0.06)4] + [8,00,000 / (1 + 0.06)5] – 3,00,000
= 4,71,061.82
The difference is Inflows – Outflows
= 4,71,061 – 3,00,000
= 1,71,061
Because inflows are more than the outflows, this is a good deal for Company A.
Why is NPV Crucial for a Business?
As stated earlier, a business needs to analyze whether a new investment project is feasible for its bottom line or not. NPV helps in determining it by accounting for the time value of money.
Unlike other theoretical measures, NPV is a numerical method that makes the decisions more sensible. It uses the present and future value at a fixed discounted rate. This makes it easier for a business to compare and know the true opportunity cost of a project and decide whether to take it or pass it.
What are the Limitations of the NPV method?
There are three main limitations of using Net Present Value.
- For the accuracy of the NPV method, the assumption of future cash flows and initial cost has to be certain. That can not be the case in reality, as predicting future cash flow is always tentative.
- Any change in the required rate of return, even of a small decimal, can have a huge impact on the cash inflows. Thus, it has to be very accurate.
- NPV can only be applied for comparing projects if they are the same in size.
Conclusion
NPV is a great tool that factors in different aspects of any investment project for a business. It accounts for the future cash flows and discounts it for the true present value. A business or a company can use this method to derive a conclusion about whether to accept an investment project or avoid it. The only drawback of the NPV method is that it assumes that future cash flows would be certain, which might not be the case in reality. Regardless, NPV is one of the most used capital budgeting methods in finance.
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