Net Present Value
The Net Present Value is the difference between the present value of cash inflows and the present value of the initial investment outlay or the cash outflows over time. The NPV Capital budgeting technique is mainly used for investment planning to analyze the profitability of a project.
Inputs of the Net Present Value
The main inputs of the net present value include:
- The projected net after cash flows in each period of the project.
- The initial investment outlay of the project at time zero.
- The appropriate discount rate of return or the weighted average cost of capital (WACC).
Net after-tax cash flows equals the total cash inflow during a period inclusive of the salvage value of the project is terminated or an asset sold after its utilization.
The initial investment outlay is equal to the total cash outflows at the inception of the project at time zero.
The appropriate discount rate of return is also equivalent to the project risk. Sometimes the discount rate or the hurdle rate is equated to the weighted average cost of capital.
Steps in Calculation of the Net Present Value
The steps involved in the calculation of the Net Present Value include the following:
- The first step in the calculation of the net present value is to estimate the total net cash inflows from the project over its life.
- The second step is to discount the cash flows at the required rate of return or the WACC.
- The third step is the summation of the present value of cash inflows.
- The fourth step is to subtract the initial investment on the project from the initial investment cost of the project to determine the net present value.
The formula for calculation of the net present value
Net Present Value = √(Rt )/((1+r)^n)
Where Rt = Net Cash inflows – Cash outflows over a period n
R = Required rate of return of the project
N = The period of investment
Example of NPV Calculation with Uneven Cash flows
An initial investment of $10,000 thousand on plant and machinery is expected to generate net cash flows of $3,000 thousand, $4,000 thousand, $5,000 thousand, and $2,000 thousand at the end of the first, second, third, fourth-year, respectively. At the end of the fourth year, the machinery will be sold for $900 thousand. Calculate the net present value of the investment if the discount rate is 15%.
|Net Present Value Technique||Column1||Column2||Column3||Column4||Column5|
|Cashflows||$ (10,000.00)||$ 3,000.00||$ 4,000.00||$ 5,000.00||$ 2,000.00|
|Salvage Value||$ –||$ –||$ –||$ –||$ 1,000.00|
|Total Cashflows||$ (10,000.00)||$ 3,000.00||$ 4,000.00||$ 5,000.00||$ 3,000.00|
|Discounting Factor @15%||1||0.8696||0.7561||0.6575||0.5718|
|Discounted Cashflows||$ (10,000.00)||$ 2,608.70||$ 3,024.57||$ 3,287.58||$ 1,715.26|
|Net Present Value||$ 636.11|
Decision Criteria for Present Net Value
If the net present value is positive, accept the project as this indicates it will be profitable in the future. On the other hand, reject projects with negative NPV. An investor is indifferent between accepting or rejecting a project with zero NPV.