MODULE 10 NPV (Net Present Value)

opportunity cost
Time Value of Money, Combination of = inflation
( Peso yesterday is better than Peso Today) risks

Net present value (NPV) is the difference between the present value of cash inflows and the present value of
cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability
of a projected investment or project. NPV is the result of calculations used to find today’s value of a future stream of
payments.

NPV = TVECF−TVIC
where:
TVECF=Today’s value of the expected cash flows
TVIC =Today’s value of invested cash
​
What Net Present Value Can Tell You
NPV accounts for the time value of money and can be used to compare similar investment alternatives.1 The NPV relies
on a discount rate that may be derived from the cost of the capital required to invest, and any project or investment
with a negative NPV should be avoided.1 One important drawback of NPV analysis is that it makes assumptions about
future events that may not be reliable.

NPV looks to assess the profitability of a given investment on the basis that a dollar in the future is not worth the same
as a dollar today. Money loses value over time due to inflation. However, a dollar today can be invested and earn a
return, making its future value possibly higher than a dollar received at the same point in the future.

NPV seeks to determine the present value of an investment's future cash flows above the investment's initial cost. The
discount rate element of the NPV formula discounts the future cash flows to the present-day value. If subtracting the
initial cost of the investment from the sum of the cash flows in the present day is positive, then the investment is
worthwhile.

Positive vs. Negative NPV

A positive NPV indicates that the projected earnings generated by a project or investment—in present dollars—exceeds
the anticipated costs, also in present dollars. It is assumed that an investment with a positive NPV will be profitable.

An investment with a negative NPV will result in a net loss. This concept is the basis for the Net Present Value Rule,
which dictates that only investments with positive NPV values should be considered.
The NPV relies on a discount rate that may be derived from the cost of the capital required to invest,
and any project or investment with a negative NPV should be avoided.

APPLICATION
The business is considering an investment in heavy equipment which will generate cash
inflow of P1,200,000 per year which could be sustained for a period of 5 years.
The cost of the heavy equipment is P5,000,000.

1. Is it advisable to proceed with the investment if the WACC (weighted average cost of capital) of the business is 5%?
5% CASH FLOW
ANSWER, Yes , assuming other thing remain constant, the NPV is positive period 1 Nominal PV

1 0.952381 1,200,000 1,142,857

Future Cash Inflow 2 0.907029 1,200,000 1,088,435
WACC 5% Yr 1 Yr 2 Yr 3 Yr4 Y5
3 0.863838 1,200,000 1,036,605
Today's Value of Investment 5,000,000
= - PV(5%,5,1200000,,0) Today's Value of Expected Cashflow 5,195,372 1,200,000 1,200,000 1,200,000 1,200,000 1,200,000 4 0.822702 1,200,000 987,243
=NPV(5%,F4:J4)-5000000 Net Present Value , Positive 195,372 5 0.783526 1,200,000 940,231

Total 6,000,000 5,195,372

@start of period, 4.545951 x 1,200,000 = 5,455,141

2. Is it advisable to proceed with the investment if the WACC (weighted average cost of capital) of the business is 7%?
ANSWER, No , assuming other thing remain constant, the NPV is negative.
Future Cash Inflow
WACC 7% Yr 1 Yr 2 Yr 3 Yr4 Y5
Today's Value of Investment 5,000,000
Today's Value of Expected Cashflow 4,920,237 1,200,000 1,200,000 1,200,000 1,200,000 1,200,000
Net
NetPresent
Present Value
Value, ,Negative
Positive -79,763