The Net Present Value (NPV) is used to evaluate a project’s financial viability. In project management, the financial gain from a project is a tangible benefit, and NPV help measures this benefit. During the feasibility study, it will be computed, and the results will be incorporated into the business case.
Return on investment (ROI), Internal Rate of Return (IRR), Payback Period (PBP), Benefit-Cost Ratio, Profitability Index, and other similar measures are also helpful while performing feasibility studies. These tools contribute their analyses to the business case, which is used to support the project.
In order to properly examine the financial metrics of projects, a project manager needs to be familiar with these tools.
What is NPV?
Definition: Net Present Value (NPV) is a profitability index considering the difference between future cash inflows and cash outflows with the discount rate.
NPV calculates the current total value of future payments.
Every business anticipates cash flows. The cash flow statement details both the revenue and the expenditures. When calculating NPV, companies look at the future cash flow in terms of its value in the present. The revenue that will be available in the future will decrease due to inflation and other risk factors. To account for inflation, businesses reduce the amount that will be paid in the future to reflect its value in the present.
When choosing between projects, NPV can be helpful. If a company can move on with only one of its several initiatives, it will choose the one with the highest net present value.
The project sponsor can assess whether or not they should proceed with the project by monitoring the investment’s net present value throughout the project’s life cycle.
NPV and Time Value of Money
Time value of money tells us that “A future dollar is worth less than a dollar today.”
A dollar today tends to depreciate in the future. As a result, companies do not take future amounts at their face value; rather, they add a discount to account for inflation and risks. This allows the companies to manage their risk exposure better. They place a greater emphasis on costs and advantages incurred earlier in the process than those incurred afterward.
It is important to remember that the discount rate has the opposite effect of the interest rate; whereas an increase in the interest rate results in an increase in the ultimate sum, the discount rate has the opposite effect.
Hence, 1,000 USD at a discount rate of 10% after two years will be worth 810 USD.
P = A(1-r)^n
= 1000 (0.9)2
= 810 USD
Smart financial investors prefer to invest in gold or silver certificates as this prevents the depreciation of their capital.
How to Calculate NPV
Again, the NPV is the sum of the present value of all cash inflows less the cash outflows.
Present value = PV=P(1+i)n
Where,
P = Future earnings
i = discount rate
n = number of years
Examples of NPV
Example-I
Find the present value of a cash flow of 4,000 USD receivable in the 3rd year of an investment if the cost of capital is assumed at 10%.
Solution
P = 4,000 USD
i= 10% = 0.1
n=3
PV=P(1+i)n
PV=4000(1+0.1)3
PV=4000(1.1)3
= 3,005.26 USD
Example-II
Let’s look at another example where NPV after one year and the NPV after three years for the same investment are compared.
A trader invested 10,000 USD at a discount rate of 10%. He expects to cash inflows of 8,000 USD for three consecutive years. Compare the NPV at the end of
- One year
- Three years
NPV after 1 year = PV1 – I
Where
PV1-Present value at the end of one year
I- Investment = 10,000 USD
PV1=P(1+i)n
PV=12,000(1+0.1)1
= 12,000/1.1
PV1 = 10,909.09 USD
NPV at the end of 1 year = 10,909.09 -10,000
= 909.09 USD
ii. At the end of three years, PV = PV1 +PV2 +PV3
PV1 as calculated= 10,909.09 USD
PV2=12,000(1+i)2
=12,000(1+0.1)2
= 9,917.36 USD
PV3=12,000(1+0.1)3
= 9,015.78 USD
So, the total present value after at the end of three years = 10,909.09 + 9,917.36 + 9,015.78
= 29,842.23 USD
Net present value at the end of three years = Total PV – I
= 29,842.23 – 10,000
NPV = 19,842.23 USD
This implies that the profitability of 10,000 USD invested over three years of constant 12,000 USD cash inflow is 19,842.23 USD.
Interpretation of NPV (Positive NPV Vs. Negative NPV)
The calculated NPV tells you about the investment profitability, as shown in the table below
NB: When comparing two projects, businesses select one with a higher NPV if both are positive.
NPV Vs IRR
The Internal Rate of Return (IRR) is the discount rate at which the NPV of an investment becomes zero. IRR uses the same formula to calculate the NPV.
IRR is used to compare different projects with different duration. If a business has multiple projects and they have to select one, they will select the project with a higher IRR.
NPV Vs Payback Period
The payback period is the time frame used to determine how long it will take for the company to recoup its initial investment. The payback period does not consider the changing value of money over time; rather, it solely computes the amount of time necessary to recover the initial investment while ignoring any associated costs.
Limitations of NPV
- When used for comparing two projects, it requires that they be of the same duration.
- It requires an estimate of the cash flow and cost of capital/discount rate, which may be inaccurate, giving misleading NPVs.
- How the project is eventually managed may override the earlier prediction of NPV.
Summary
A financial investing instrument known as net present value (NPV) evaluates the viability of investment by considering future cash flows and discounting them to their present-day equivalents. In this manner, the profitability of the investment, as well as its value, may be determined to make decisions.
References
- Net Present Value Calculations (managementstudyguide.com)
- Net Present Value (NPV): How to Calculate Net Present Value – 2022 – MasterClass
- Proceedings of the 2022 7th International Conference on Financial Innovation and Economic Development (ICFIED 2022): Analysis of the Net Present Value and Equivalent Annual Cost in Optimal Machine Life
- Analysis of the Net Present Value and Equivalent Annual Cost in Optimal Machine Life | Atlantis Press (Atlantis-press.com)
- Net Present Value Explained – What Is NPV? | Shark Finesse Ltd
- Net present value – Wikipedia
- Net Present Value: A Definition | Rocket HQ
- Using the Net Present Value Rule to Make Value-Creating Investment Decisions | Atlantis Press (Atlantis-press.com)
- UK-net-present-value-brochure.pdf (stantec.com)
- Discount Rate: DCF Formula and Cost of Capital Calculator (wallstreetprep.com)