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NET PRESENT VALUE

It is always challenging to calculate and determine the exact project


monetary value due to the unpredicted cash outflow and inflow. There have
been several methods introduced and used throughout the world, but the Net
Present Value (NPV) method was found to be one of the most useful and
reliable technique for this process. It is the difference between the present
value of the expected cash inflows in future and the amount invested on the
project. NPV incorporates the time value of money (TVM) for its future cash
inflow calculation, which is a very important concept and terminology widely
discussed and utilized even in the introductory finance. The concept of TVM
could simply be explained as the difference in value of money with respect to
time. Because, money in the present is worth more than the same amount in
the future. Apparently, this could be justified based on 'inflation' or say the
extra earnings/'interests' that could potentially be made using that same
investment during the intervening time. In short, a dollar which you might get
tomorrow is probably less worthy than a dollar in your hand right now.

So, while calculating the future returns or cash inflow of a project, this
deterioration in money value has to be taken into account. The NPV
successfully incorporate this discount rate element into its calculation and is
hence generally viewed as a more credible and reliable method of calculating
the present value of a project. The present value thus calculated for the
expected cash flows by discounting them at the required rate of return (Kurt D.
,2017). Let's consider an example, Say a project with a 1 year span has a total
investment of $1000 and is expected get a revenue of say $2000 in that year.
Here the investment is cash outflow and the revenue is cash inflow. But we
cannot take into consideration the total $2000 as cash inflow, as its the money
we might get in future. Hence we have to discount this revenue by a discount
rate, say 10%. So, by discounting 10% to future $2000 gain (using eq.a), we
consider only $1818 as cash inflow. Now the total Net present value is
$1000+$1818=$818. Hence the total net present value after discounting the
future return is $818. A zero net present value means that the project repays
the original investment which were put on the project plus the required rate of
return, which could be same as investing the money in a bank and collecting
the interest revenue.
A positive net present value means a better return, indicating that the
projected earnings generated exceeds the anticipated costs, which
recommends, that it will be a good idea to go forward with the project. And a
negative net present value means a worse return, in which case it's better to
discard the project as it will probably result in a net loss (Taylor &
Francis,2017). The discount rate element to be considered for NPV calculation
is to be determined based on many factors. Different companies follow
different methodologies in determining this rate, of which a more popular one
is using the expected return of other investments of having similar
characteristics, risks and rewards (Kurt, D. ,2017). . The interest rate charged
for borrowing money for the investment of a project could also be a good
indication of the prevalent discount rate. Financing institutions and banks
calculate their interests rate on loans based on similar ideology.

Let's consider the expected future amount be F and the present value of this
amount be 'P'. Now let the interest rate considered be i, and the number of
years after investment where the revenue is expected be 'n'.

1
F = P(1 + 𝑖)n 𝑜𝑟 P=F (Eq. a)
(1 + 𝑖)n

1
Here is the Present Value factor or Discount factor.
(1+𝑖)n

If the project is expected to gain the same amount of cash inflow every year
continuously for say 'n' number of years , we can use the annuity formulae.
Consider 'A' as cash inflow (same for all the years).
1 1 1 1
P = A { (1+𝑖)1 + (1+𝑖)2 + (1+𝑖)3 … … … + (1+𝑖)1 }

(1+𝑖)n − 1
P= A (Eq. b)
𝑖.(1+𝑖)n
(1+𝑖)n − 1
Here is the Present Value factor for an annuity
𝑖.(1+𝑖)n
Now to find the Net present value of a project,
L𝑛
NPV= -I0 + (B − C)𝑃𝑉𝐹𝑖,𝑛 +
(1+𝑖)𝑛

I0 - Initial Capital Investment


B - Annual net benefits
C - Annual net costs
i - Discount rate
n - Number of years
(1+𝑖)n − 1
𝑃𝑉𝐹𝑖,𝑛 = - Present value factor for annuity
𝑖.(1+𝑖)n
L𝑛 - Liquidation yield

*Calculations to be added
*Annual income/expense, Project life span, Resale value to be finalized.

REFERENCE
Scott, M. (2011). Small company economics–net present value versus net cash
flow. The APPEA Journal, 51(1), p.369.

Taylor & Francis. (2017). FREE CASH FLOW (FCF), ECONOMIC VALUE ADDED
(EVA™), AND NET PRESENT VALUE (NPV):. A RECONCILIATION OF VARIATIONS
OF DISCOUNTED-CASH-FLOW (DCF) VALUATION. [online] Available at:
http://www.tandfonline.com/doi/abs/10.1080/00137910108967561
[Accessed 11 Oct. 2017].

Kurt, D. (2017). Net Present Value - NPV. [online] Investopedia. Available at:
http://www.investopedia.com/terms/n/npv.asp [Accessed 11 Oct. 2017].

BusinessDictionary.com. (2017). What comes after those ellipses?. [online]


Available at: http://www.businessdictionary.com/definition/net-present-value-
NPV.html [Accessed 11 Oct. 2017].