Understanding Net Present Value (NPV) – With Examples
What is Net Present Value? • Net present value is the difference between present value of cash inflows and present value of cash outflows. • Net Present value is used for evaluating projects more often as compared to other methods (like, pay-back period, average rate of return etc.). This is because it takes into consideration the time value of money. • Project evaluation includes investment in or replacement of a fixed asset, investment or acquisition of a Company or Investment in a Capital-intensive project or Research and development project. Email: Support@skillfinlearning.com
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Why is project evaluation is important? Involves large investments
Maximize shareholder wealth
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Project Evaluation
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What is Time Value of money? Time Value of Money ($) • Time value of money means that cash flows received today are worth more than cash flows to be received in the future. • This is because of inflation and other investment opportunities which the investor may have • For example, if you have the option of receiving $10,000/- today or in future. You should opt to receive it today as you have the option to invest it and earn income on it. • Value of money decreases with time Email: Support@skillfinlearning.com
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Value declines with time
How is NPV calculated?
NET PRESENT VALUE
=
PRESENT VALUE OF CASH INFLOWS (-)
PRESENT VALUE OF CASH OUTFLOWS ACCEPT – REJECT CRITERIA IF THE NPV IS POSITIVE IF THE NPV IS NEGATIVE Email: Support@skillfinlearning.com
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Example (1/5) • ABC is considering investment of $100,000 in a manufacturing facility. The project is expected to generate cash flows for 5 years as follows. Amount Year 0
($100,000)
Year 1
$20,000
Year 2
$20,000
Year 3
$30,000
Year 4
$30,000
Year 5
$25,000
• At the end of the 5th year the manufacturing facility can be sold off for $15,000/-. Cost of capital is 10%. You are asked to evaluate the project. Email: Support@skillfinlearning.com
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Example (2/5) CASH FLOW TIME-LINE
$20,000
$20,000
$30,000
TERMINAL VALUE $15,000 $25,000 $30,000
Cost of Capital = 10% $100,000 YEAR 0 Email: Support@skillfinlearning.com
YEAR 1
YEAR 2
YEAR 3
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YEAR 4
YEAR 5
Example (3/5)
NET PRESENT VALUE
=
PRESENT VALUE OF CASH INFLOWS (-)
PRESENT VALUE OF CASH OUTFLOWS Present Value
=
FUTURE VALUE (1+r)^n r = cost of capital, n = time period
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Example (4/5)
Present Value (YEAR 1) =
$20,000
=
$18,181.82
=
$16,528.93
=
$24,836.85
(1+10%)^1 Present Value (YEAR 2) =
$20,000 (1+10%)^2
Present Value (YEAR 5) =
$40,000 (1+10%)^5
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Example (5/5) Here is the summary of the cash flows YEAR 1 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Amount ($100,000) $20,000 $20,000 $30,000 $30,000 $40,000
Present value (Amount $) ($100,000.00) $18,181.82 $16,528.93 $22,539.44 $20,490.40 $24,836.85
Present value of cash Inflows Present value of cash outflows Net Present Value
$102,577 ($100,000) $2,577
ACCEPT – REJECT DECISION SINCE THE NPV IS POSITIVE Email: Support@skillfinlearning.com
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Advantages of using Net Present Value
Considers Time Value of Money
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Considers entire project lifecycle cash flows into consideration
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Aligned to management objective of maximizing shareholder value
Disadvantages of using Net Present Value
Calculation of discount rate/ cost of capital may be difficult
The forecasting of cash flows may be difficult because of several uncertainties
It accepts or rejects the projects only based on value; doesn’t consider the cost of initial cash outlay
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Summary
• NPV is an effective measure for evaluating investments. • To compute the Net Present value, a firm should determine the cash inflows and the outflows along with the discount rate or a rate of return that firm desires during the lifetime of the project. • However, in certain circumstances NPV may not be a conclusive measure. The firm should also consider the riskiness or limitation of forecasting future cash flows, availability of capital, external environment etc. before making the investment decision.
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