NPV (Net Present Value

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The difference between the present value of cash inflows and the present value of cash outflows. NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. NPV is used in capital budgeting to analyze the profitability of an investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield. Cash flows can be ve and un-even. Cash flows must occur at regular intervals, such as monthly or annually Accept the project if NPV is positive Reject the project if NPV is negative

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55 $50 Added Value Initial Investment This is the definition of NPV . What is our increase in value given a 10% expected return? 60 Profit = -50 + ! $4.10 $4.NPV (Net Present Value) Example Suppose we can invest $50 today and receive $60 in one year.55 1.

How much would you be willing to pay for the building? Cost of Capital being 7% Refer the Excel .000 per year in cash flows for three years.NPV (Net Present Value) Example You have the opportunity to purchase an office building. You have a tenant lined up that will generate $16.000. At the end of three years you anticipate selling the building for $450.

would you buy the building and what is the added value generated by your purchase and management of the building? 16.07 ) (1.07 ) (1.000 NPV ! 350.000    1 2 3 (1.000 466.000 16.323 .NPV (Net Present Value) Example .07 ) NPV ! $59.continued If the building is being offered for sale at a price of $350.000.

Discount rate at which NPV = 0. the more desirable it is to undertake the project Accept if IRR > Cost of Capital Reject if IRR < Cost of Capital .IRR (Internal Rate of Return) ‡ ‡ ‡ ‡ ‡ Internal Rate of Return (IRR) . The internal rate of return measures the investment yield IRR is sometimes referred to as "economic rate of return (ERR) The higher a project's internal rate of return.rate of growth a project is expected to generate Cash flows can be ve and un-even. IRR .

96% . At the end of three years you will sell the building for $450. The investment will generate $16. rent) during the first three years.000 466 . 000 !   1 2 (1  IRR ) (1  IRR ) (1  IRR ) 3 IRR = 12.000. 000 16 . 000 350 .IRR (Internal Rate of Return) Example You can purchase a building for $350.000.000 in cash flows (i. What is the IRR on this investment? 16 .e.

IRR (Internal Rate of Return) 200 150 100 NPV (.000s) 50 0 -50 -100 -150 -200 Discount rate (%) 0 5 10 15 20 25 30 35 .

It shows the discount rate below which an investment results in a +ve NPV (and should be accepted) and above which an investment results ve NPV (and should be rejected). It is the breakeven discount rate. the rate at which the value of cash outflows equals the value of cash inflows .NPV and IRR NPV shows the value of a stream of future cash flows discounted back to the present by some % that represents the minimum desired rate of return. often your cost of capital IRR computes a break-even rate of return.

IRR ‡ IRR's major limitation is also its greatest strength: it uses one single discount rate to evaluate every investment. and a shorter time horizon. For example. so it's just not adequate for longer-term projects with discount rates that are expected to vary ‡ ‡ ‡ .NPV Vs. Although using one discount rate simplifies matters. predictable cash flows. IRR will probably work In real discount rates usually change substantially over time. think about using the rate of return on a T-bill in the last 20 years as a discount rate. One-year T-bills returned between 1% and 12% in the last 20 years. Without modification. both of which share a common discount rate. equal risk. there are a number of situations that cause problems for IRR If an analyst is evaluating two projects. so clearly the discount rate is changing. IRR does not account for changing discount rates.

com/en-us/excel-help/go-with-the-cash-flow-calculate-npv-and-irr-in-excelHA001113632. ‡ Another situation that causes problems for users of the IRR method is when the discount rate of a project is not known. the project is feasible.aspx http://www. . if it is below. it must be compared to a discount rate.com/ask/answers/05/irrvsnpvcapitalbudgeting.microsoft. . In order for the IRR to be considered a valid way to evaluate a project. the project is considered infeasible.investopedia. IRR Cont.asp ‡ ‡ ‡ . In case of multiple IRRs (3) you don t know which one to use Whenever there is a conflict between NPV and IRR the correct answer is provided by NPV Reference Material: ± ± http://office. If the IRR is above the discount rate.NPV Vs.

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