Net Present Value is the difference between the present value of cash inflows and the present value of cash outflows over a period of time for a project or investment. It is one of the most commonly used forms of project valuation as it is relatively easy to calculate and interpret. Positive Net Present Values are a general indication of profitability of a project while negative values of NPV are considered poor investment decisions.
Although the Net Present Value takes future values of cash inflows and adjusts for financial factors to give a present value, it does not account for unforeseen events or changes in the financial future, thus it should be used cautiously by investors for projects with long maturity periods.
The NPV of a sequence of cash flows takes as input the cash flows and a discount rate or discount curve and outputs a present value, which is the current fair price.
The initial investment value is the initial cash outflow required to start a project. In the Net Present Value calculation, this value is negative as it reflects the sunk costs of initialising the project.
Periodic cashflow payments are the expected or predicted cash inflows of a project from period to period, for the duration of the project’s life. They may be the expected profit for a period minus expenses required to maintain the project for that period.
The discount rate is the rate in which future cashflows are discounted to adjust for financial factors such as inflation and interest. This variable can also be the rate of return required by investors when considering a project for investment.
The time to maturity is the number of periods, often expressed in years, that a project will run before reaching maturity or being retired.
The Net Present Value (NPV) is the future value of a project after calculating the NPV formula. This value is used by investors to make investment decisions based on whether the calculation returns a positive or negative value.
NPV analysis is used to help determine how much an investment, project, or any series of cash flows is worth. It is an all-encompassing metric, as it takes into account all revenues, expenses, and capital costs associated with an investment in its Free Cash Flow.
Assume a project manager is considering investment in a project on behalf of the company they work for. The project has an initial investment cost of $50,000 and will provide cash inflows every year for 7 years. The expected cash inflows for the next 7 years are as follows; $12,000, $18,000, $10,000, $7,000, $14,500, $6,000, and $9,000 for each period, respectively. The company has a required rate of return of 10%. Using the NPV formula, the Net Present Value of the project to the company can be calculated as follows:
NPV = -C0 + Σ ( Cn / (1 + r)t )
NPV = -$50,000 + ( $12,000 / (1 + 0.1)1 ) + ( $18,000 / (1 + 0.1)2 ) ) + ( $10,000 / (1 + 0.1)3 ) ) + ( $7,000 / (1 + 0.1)4 ) ) + ( $14,500 / (1 + 0.1)5 ) ) + ( $6,000 / (1 + 0.1)6 ) ) + ( $9,000 / (1 + 0.1)7 )
NPV = $5,087.99
In this example, the project manager would calculate an NPV of $5,087.99 for this project. As the NPV is positive, the project is eligible for consideration.
If 2 mutually exclusive projects were being considered by the project manager, however, and the second project yielded an NPV of $7,000, the project manager would be inclined to choose the second project with the higher NPV.
When managers and investors need to compare projects and decide which ones to pursue, there are generally three options available: internal rate of return, payback method, and net present value. Net Present Value, often referred to as NPV, is the tool of choice for most financial analysts. There are two reasons for this. The first is NPV considers the time value of money as it translates future cash flows into today’s value. The second is it provides a concrete number that managers can use to easily compare an initial outlay of cash against the present value of the return.
Another advantage of the NPV is the ability for project managers to compare mutually exclusive projects with the NPV. Should one project yield a higher NPV than the other, the project with the higher NPV would be considered over the other as it would yield a higher return for the investment, assuming all initial investment costs were the same or similar.
Net present value discounts all the future cash flows from a project and subtracts its required investment. The analysis is used in capital budgeting to determine if a project should be undertaken when compared to alternative uses of capital or other projects. As the NPV is relatively easy to calculate, it is often used by investors and project managers for a fast analysis of a project, along with the Accounting Rate of Return (ARR) and the Payback Period methods.
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