Net Present Value
Net present value is the present value of future cash inflows and outflows. Net Present Value is basically used in capital budgeting to study the profitability of project or investment. It is most widely used tool when managing budgeting decisions. It is defined as the difference between present valuesof cash inflows and outflows. Net Present Value uses discounted cash flow techniques to find the value of cash flows of project in the present and future. The rule of thumb for NPV project is that project with positive cash flows will be accepted and project with negative preset value will be unacceptable. The NPV assumes that all cash flows will be reinvested at the same rate that is required to discount cash flows. In calculating project's Net Present value, the cash flows at different period of time are modified using the discount rate, which is the required rate of return of project. Net Present value compares dollar today to the value of same dollar at a future date taking inflation and risk into consideration.(Eugene F. Brigham,2004)
Following formula is used to calculate Net Present value
NPV = CF0 / (1+k) ^0 + CF1 / (1+k) ^1 + .......CFn / (1+k)^n + CFt / (1+k)^t - CO0
CFt = Cash flow occurring at the end of year t. A cash outflow has a negative sign.
n = Life of the project
k = Cost of Capital (required rate of return) used as the discount rate
NPV = 0, reject project
NPV >0, accept project
A project's NPV depends upon the discount rate, higher the discount rate, lower the Net Present Value and vice versa.
In case of mutually exclusive projects, Project with higher NPV is accepted.
Characteristics of Net Present value
- It considers time value of money.
- It incorporates the timing and dimensions of cash flows as well as inflation and risk associated with the estimations.
- It uses discounting technique to calculate the present value of future cash flows.
- A project is acceptable, if sum of present value of future cash flows is more than initial investment.
- A positive Net Present Value means that project will give positive cash flows and thus decision to undertake project is correct decision
- The calculation of net present value is sensitive to the discount rate used.(Richard A. Brealey,2003)
If the present value of a project is $ 5 million and the initial investment of project is $ 2 million; this means that project is having positive net present value of $ 3million.
Similarly if the present value of project is $ 600,000 and initial investment is $1 million, the net present value of project will be negative i.e. ($400,000) and project will not be accepted.
Role of NPV in capital decisions
Net present Value method is used to measure the financial viability of projects. For calculating Net Present value, all relevant cash flows are identified. In evaluating a project, all the receipts are written under the cash inflows and all costs are written under the cash outflows. The cash inflows and outflows are discounted by using cost of capital i.e. Weighted Average Cost of Capital. All the present values are summed together and resultant is deducted from the initial investment. A project with higher or positive Net Present value preferred over the project with lower or negative present value.(Douglas R. Emery, 2007)
Advantages of using Net Present Value Method
The NPV method takes into consideration the time value of an investment opportunity by discounting the cash flows (Douglas R. Emery, 2007). It is better than other methods as it considers only the cash receipts and expenses, depreciation, management taste or profits from existing business does not affect the decisions. Also, Net Present Value uses all cash flows of project as compared to other method such as payback method which does not consider cash flows after the payback period. (Ross, 2009) It is considered as one of the best technique because it measures profitability, measures risk, consider all cash flows, adjusts cash flows for time value of money and consistent with the wealth maximization goal. NPV technique can be used specially for large projects where huge funds are involved. (Belverd Needles, 2001)
Disadvantages of using Net Present Value
There are many drawbacks of this method. It sometimes shows inconsistent behaviors. It is possible that NPV increases as the discount rate increases or decreases as discount rate falls (Oehmke, 2009). This makes NPV method to be less useful specially when for evaluating highly risky capital projects. It underestimates all investment projects, which results in strong statements that no decision should be taken in future after the investment decision. (Belverd Needles, 2011) It is regarded as one of the most complicated method.