THE NET PRESENT VALUE (NPV)

DNU
4 THE NET PRESENT VALUE
4.1 Introduction

Investment decisions are among the most important decisions companies make and
these usually imply many opportunities and investment projects, as for example:
opening a new factory, launching a new production line, buying another company,
etc. For this reason, the analysis of the investment project is fundamental, it helps
determine which projects are to be considered “good” and which “bad”, that is,
which will lead to maximizing the company’s value and, therefore, the stockholders’
wealth, and which not. We, then, need to obtain answers to two fundamental
questions:

 What projects are to be chosen among the different alternatives

presented?
 How many projects are to be accepted?

Investment projects can be valued in different ways, and these not always produce
coinciding results. We are going to start studying the NPV method to analyze
investments because, as we will see, it has important advantages and it is one of the
most commonly used methods by large companies.

4.2 The concept of the net present value.

The net present value (NPV) of an investment, also known as capital value, is
equal to the difference between the discounted value of the expected cash
flows and the value of the, also discounted, forecast payments. Therefore, it is
convenient to carry out only those investments whose NPV results positive, because
these are the only ones which will contribute to a value increase. When there are
various investments with a positive net present value, we are to give priority to
those whose net present value is higher.

Let’s give an example: suppose we have today 100 euros and we deposit them in a
bank for a period of three years at an interest rate of the 10%. Then, at the end of
the three-year period, we will have:

FV = 100 × 1.13 = 133.1€

Now, let’s imagine that two further investment opportunities appear for our 100
euros. The first opportunity will give us a return of 30 euros at the end of the first
year, 40 euros at the end of the second, and 50 euros at the end of the third. The
second opportunity offers a return of 50 euros at the end of the first year, 40 euros
at the end of the second and 30 euros at the end of the third.

Considering this, and if we do not have any other investment as a reference, the two
alternatives would seem satisfactory for our money, as we would be turning 100
euros into 120. However, the existence of the initial opportunity allows us to
suppose we can invest these amounts of money at a 10% interest rate, which is what
I would obtain by placing my money in the bank. This would imply for the two

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further offers a higher value than the previous 120 euros. We can make an
approximate calculation of the final value, comparing the initial offer whose details
we already know to the other two offers.

FV = 100 × 1.13 = 133.1€

FVOffer1 = 30 × 1.12 + 40 × 1.11+ 50 × 1.10 = 130.3€

FVOffer2 = 50 × 1.12 + 40 × 1.11+ 30 × 1.10 = 134.5€

We observe that the second offer (offer 2) is better than our initial investment, as
the final value is higher than 133.1 euros. For the same reason, the first offer (offer
1) is worse than the initial one. So, under these circumstances, if we could choose
between these two possible alternatives, we would opt for offer 2, whose income of
return, invested at a 10%, will turn into a higher quantity in three-year time.

We are now going to carry out our analysis by applying the rule of the present value
and bearing in mind that the initial investment interest rate is 10%. Under those
circumstances, we would obtain the following:
,
PVInitial = 100€ = ,

PVOffer1= 97.9 €= ,
+ ,
+ ,

PVOffer2 = 101.05€ = ,
+ ,
+ ,

Thus, we will arrive to the same conclusion that we have would arrived to by using
the quantity of the final value, that is, offer two is better than the initial offer and
offer one is worse. We will choose offer two because it is the one with the highest
present value, 101.05, which is higher than all the rest. This means that offer two
produces more money than our initial investment, in fact 1.05 euros more when
talking about present value.

However, the easiest way to compare different investment possibilities is by using

the Net Present Value (NPV), that is, as we mentioned at the beginning, no more than
the difference between the money invested and the money that will be recuperated
in the future in terms of present value or, what is the same, discounted at the rate
available in our investment market.

In our case, the NPV of the two offers, in comparison to the initial one, would be the
following:
,
NPV Original = 0 = -100 + 100 = .

NPV Offer1 = -2.1 = -100 + 97.9 = .

+ .
+ .

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 NPV Offer2 = 1.05 = -100 + 101.05 = .
+ .
+ .

Then, the money produced by the initial investment has, by definition, a present
value of 100 euros. Therefore, its NPV, that is, the quantity we recuperate in terms
of present value minus what we invest would be equal to zero. This is obvious due
to the fact that the initial investment compared to its self cannot differ in any
quantity. This investment does not reflect anything else than what we can obtain in
our reduced investment market. It also facilitates us the discount rate so as to
calculate de NPV of the two possible offers and see which one will contribute with a
higher value, that is, which one will have a higher NPV.

If we analyse offer one, we observe it has a negative NPV of 2.1 euros, which means
that we will not be earning that quantity, compared to what we can easily obtain in
the market, that is what our initial investment shows. Consequently, the negative
NPV quantifies the money that we will not be earning in the future, in a specific
investment, with respect to another one used as reference.

If we now concentrate on offer two, we see it has a positive NPV of 1.05 euros that
comes from discounting the existing difference between the final value and the value
of the initial investment. Therefore, a positive NPV quantifies the present value we
would be additionally earning in the future in a specific investment, with respect to
another one used as reference.

As a result, we can consider that the NPV is a useful discriminator for investment as
it distinguishes between those in which we can earn more money with respect to
another pre-existing one, and how much more, compared to those in which we can
earn less, and how much less. The general expression of the NPV is the following:
𝐂𝐅𝟏 𝐂𝐅𝟐 𝐂𝐅𝐧
NPV= -IInitial + PVFuture income or cash flows = -IInitial + (𝟏 𝐢)
+ (𝟏 𝐢)𝟐
+ ⋯ + (𝟏 𝐢)𝐧

Therefore, the NPV really measures if a project creates or destroys wealth. Hence,
according to this criterion, an investment is more feasible when the NPV is higher
than zero and, among different investment alternatives, those whose NPV is higher
would be preferable as those projects will be the ones contributing with a higher
value to the company. If the NPV is equal to zero, it would mean that the project will
generate enough cash flows (money) so as to pay the interest rate of the external
financing we asked for and the expected investment return of our internal financing.

Table– Decision Criterion base don NPV

RESULT OBTAINED ECONOMIC INTERPRETATION DECISSION TO BE MADE

NPV > 0 Net benefits We accept the Project

NPV = 0 No benefits, no loss Indifference

NPV < 0 Net loss We reject the project

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What does it mean that our wealth increases with the NPV? Illustrative example:

Let’s suppose we have “only” 450,000 Euros and that we “take the plunge” creating
a mini-company that is capable of generating a cash flow of 90,000 euros annually
during the next 8 years.

Now, let’s suppose we immediately sell our mini-company to a larger company.

What this new company will be buying is a business that, during the next years, will
obtain the following:

Income
90.000 90.000 90.000 90.000 90.000 90.000 90.000 90.000

0 1 2 3 4 5 6 7 8

Due to the business risk level, the company buying our business would desire a
profitability or return of the 10%, so it will be willing to pay us the value of the cash
flow estimated at this rate, that is:
( . )
Value= 90,000 × . ×( . )
= 480,143.36

Thus, this morning we had 450,000 euros, we set up the business and we have sold
it for 480,143.36 euros, we are 30,143.36 euros richer!

4.3 The concept of cash flow – A brief introduction

When we start talking about investments and calculating the NPV of an investment,
the term "cash flows" appear, and it is what we are going to discount to calculate the
present value of an investment. It is the "real money" that we are going to receive
for making an investment, and it is different from the net profit of the company.

What a cash flow is relatively simple to understand, it is the difference between the
amount of money received and the amount paid. And this does not coincide with the
bottom line of the profit and loss account, some "adjustments" are needed. For
example, when accountants prepare a company's profit and loss account they
include as profit earned what has been invoiced to a client, even if it has not yet been
paid. This is what is known as the accrual principle. In addition, cash outflows are
classified into two different categories: current expenditures and capital
expenditures. To calculate profit current expenses are deducted, but not capital
expenditures. Capital expenditures are amortized, that is, they are "charged" over
several years and are deducted from the profit of several years. Therefore, the profit
includes some cash flows and others not, and is reduced by the amortization quotas,
which are not cash flows.

Do not assume that you can find cash flow by routine manipulation of accounting
data.

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Note: We will study a stylized example.

4.4 The concept of opportunity cost – A brief introduction

The opportunity cost represents what we would lose from investing in one project
rather than in another. When we invest our money in a specific project, we lose the
opportunity to invest in another project that would give us benefits that we can
never receive. So, what we use as a discount rate when calculating the NPV is this
opportunity cost, which is nothing more than what we would lose from investing in
something else. The opportunity cost is related with the risk of the project, if the risk
is high the opportunity cost of capital will be high and vice versa, as nobody is willing
to make a risky investment if they are not going to earn more money that if they
invest in a non-risky project. It is considered that there is no risk when cash flows
are true, for example, in the case of government bonds. Then if we make an
investment without risk the opportunity cost of capital will be what the state pays if
you invest in its bonds, which incorporates the real interest rate and the expected
annual inflation. If the investment that we are going to carry out is risky we will have
to compare it with another one of similar risk.

4.5 NPV advantages

This criterion presents two main advantages. The first one is the simplicity of its
calculations, as it only requires carrying out elementary mathematical operations.
The second, bearing in mind the different value of money throughout time, as,
obviously, the quantity of money available today has more value than the same
quantity of money available in a more or less near future. In terms of Brealey y
Myers, “the NPV recognises that a dollar today is worth more than a dollar
tomorrow, due to the fact that a dollar today can be invested so as to begin to
generate interests immediately. Any reinvestment rule that does not recognise the
value of money throughout time cannot be considered intelligent”.

4.6 NPV Drawbacks

It considers the reinvestment of intermediate cash flows that are generated at

an interest rate “i” until the end of the investment.

In the duration periods of an investment, a cash flow, supposedly not inactive, is

produced and reinvested in another investment until the year n, set as the final one
of the project. When we calculate the NPV, we are implicitly assuming that the rate
of reinvestment is the same as the one used as discount rate. Therefore, this criterion
presupposes that the net cash flows provides a profitability or return equal to the
discount rate used and that the negative cash flows will be equally financed by the
mentioned rate. Hence, if once we have started the project, the cash flows are
reinvested at a different rate to the discount rate used to calculate the NPV, the result
will differ from that obtained with this criterion.

The difficulty of specifying the discount rate

The interest rate that is used in the calculation of the net present value, is considered
to be the interest that governs the financial market, that is, the opportunity cost of

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capital. But here is where the hypothesis of the financial market perfection is based,
that is, in the fact that such a rate will exist as such and that any person or company
can turn to the market and find that return or profitability without limits. However,
the financial market is imperfect, fact which makes more difficult determining such
a rate.