Net Present Value (NPV)

Net present value is the present value of net cash inflows generated by a project including
salvage value, if any, less the initial investment on the project. It is one of the most
reliable measures used in capital budgeting because it accounts for time value of money
by using discounted cash inflows.
Before calculating NPV, a target rate of return is set which is used to discount the net cash
inflows from a project. Net cash inflow equals total cash inflow during a period less the
expenses directly incurred on generating the cash inflow.
Calculation Methods and Formulas
The first step involved in the calculation of NPV is the determination of the present value
of net cash inflows from a project or asset. The net cash flows may be even (i.e. equal cash
inflows in different periods) or uneven (i.e. different cash flows in different periods).
When they are even, present value can be easily calculated by using the present value
formula of annuity. However, if they are uneven, we need to calculate the present value
of each individual net cash inflow separately.
In the second step we subtract the initial investment on the project from the total present
value of inflows to arrive at net present value.
Thus we have the following two formulas for the calculation of NPV:
When cash inflows are even:

1 − (1 + i)-n
NPV = R × − Initial Investment
i

In the above formula,

R is the net cash inflow expected to be received each period;
i is the required rate of return per period;
n are the number of periods during which the project is expected to operate and generate
cash inflows.
When cash inflows are uneven:

R1 R2 R3
NPV = + + + ... − Initial Investment
(1 + i)1 (1 + i)2 (1 + i)3

Where,
i is the target rate of return per period;
R1 is the net cash inflow during the first period;
R2 is the net cash inflow during the second period;
R3 is the net cash inflow during the third period, and so on ...
 Decision Rule
Accept the project only if its NPV is positive or zero. Reject the project having negative
NPV. While comparing two or more exclusive projects having positive NPVs, accept the
one with highest NPV.
Examples
Example 1: Even Cash Inflows: Calculate the net present value of a project which requires
an initial investment of $243,000 and it is expected to generate a cash inflow of $50,000
each month for 12 months. Assume that the salvage value of the project is zero. The
target rate of return is 12% per annum.
Solution
We have,
Initial Investment = $243,000
Net Cash Inflow per Period = $50,000
Number of Periods = 12
Discount Rate per Period = 12% ÷ 12 = 1%
Net Present Value
= $50,000 × (1 − (1 + 1%)^-12) ÷ 1% − $243,000
= $50,000 × (1 − 1.01^-12) ÷ 0.01 − $243,000
≈ $50,000 × (1 − 0.887449) ÷ 0.01 − $243,000
≈ $50,000 × 0.112551 ÷ 0.01 − $243,000
≈ $50,000 × 11.2551 − $243,000
≈ $562,754 − $243,000
≈ $319,754
Example 2: Uneven Cash Inflows: An initial investment on plant and machinery of $8,320
thousand is expected to generate cash inflows of $3,411 thousand, $4,070 thousand,
$5,824 thousand and $2,065 thousand at the end of first, second, third and fourth year
respectively. At the end of the fourth year, the machinery will be sold for $900 thousand.
Calculate the present value of the investment if the discount rate is 18%. Round your
answer to nearest thousand dollars.
Solution
PV Factors:
Year 1 = 1 ÷ (1 + 18%)^1 ≈ 0.8475
Year 2 = 1 ÷ (1 + 18%)^2 ≈ 0.7182
Year 3 = 1 ÷ (1 + 18%)^3 ≈ 0.6086
Year 4 = 1 ÷ (1 + 18%)^4 ≈ 0.5158
The rest of the problem can be solved more efficiently in table format as show below:
Year 1 2 3 4

Net Cash Inflow $3,411 $4,070 $5,824 $2,065

Salvage Value 900

Total Cash Inflow $3,411 $4,070 $5,824 $2,965

× Present Value Factor 0.8475 0.7182 0.6086 0.5158

Present Value of Cash Flows $2,890.68 $2,923.01 $3,544.67 $1,529.31

Total PV of Cash Inflows $10,888

− Initial Investment − 8,320

Net Present Value $2,568 thousand

Advantage and Disadvantage of NPV

Advantage: Net present value accounts for time value of money. Thus it is more reliable
than other investment appraisal techniques which do not discount future cash flows such
payback period and accounting rate of return.
Disadvantage: It is based on estimated future cash flows of the project and estimates may
be far from actual results.
Net present value method
Net present value method (also known as discounted cash flow method) is a popular
capital budgeting technique that takes into account the time value of money. It uses net
present value of the investment project as the base to accept or reject a proposed
investment in projects like purchase of new equipment, purchase of inventory,
expansion or addition of existing plant assets and the installation of new plants etc.

First, I would explain what is net present value and then how it is used to analyze
investment projects.

Net present value (NPV):

Net present value is the difference between the present value of cash inflows and the
present value of cash outflows that occur as a result of undertaking an investment
project. It may be positive, zero or negative. These three possibilities of net present
value are briefly explained below:

Positive NPV:

If present value of cash inflows is greater than the present value of the cash outflows,
the net present value is said to be positive and the investment proposal is considered to
be acceptable.

Zero NPV:

If present value of cash inflow is equal to present value of cash outflow, the net present
value is said to be zero and the investment proposal is considered to be acceptable.

Negative NPV:

If present value of cash inflow is less than present value of cash outflow, the net present
value is said to be negative and the investment proposal is rejected.

The summary of the concept explained so far is given below:

The following example illustrates the use of net present value method in analyzing an
investment proposal.
Example 1 – cash inflow project:
The management of Fine Electronics Company is considering to purchase
an equipment to be attached with the main manufacturing machine. The
equipment will cost $6,000 and will increase annual cash inflow by $2,200.
The useful life of the equipment is 6 years. After 6 years it will have no
salvage value. The management wants a 20% return on all investments.

Required:

1. Compute net present value (NPV) of this investment project.

2. Should the equipment be purchased according to NPV analysis?

Solution:

(1) Computation of net present value:

*Value from present value of an annuity of $1 in arrears table.

(2) Purchase decision:

Yes, the equipment should be purchased because the net present value is positive
($1,317). Having a positive net present value means the project promises a rate of return
that is higher than the minimum rate of return required by management (20% in the
above example).

In the above example, the minimum required rate of return is 20%. It means if the
equipment is not purchased and the money is invested elsewhere, the company would be
able to earn 20% return on its investment. The minimum required rate of return (20%
in our example) is used to discount the cash inflow to its present value and is, therefore,
also known as discount rate.

Investments in assets are usually made with the intention to generate revenue or reduce
costs in future. The reduction in cost is considered equivalent to increase in revenues
and should, therefore, be treated as cash inflow in capital budgeting computations.