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Net Present Value - Explanation

Net present value is used by project managers, business owners, decision makers and economics professionals. It is a formula used in capital budgeting to evaluate the value of a project or capital investment and in an economics application it is used to evaluate cash flows. Net present value is also known as NPV.

While NPV is widely used as a measure for considering investment decisions, it is important for the decision maker to be aware of the risk involved with evaluating the results. The risks that are presented by NPV occur as a result of imperfect cash flow estimates. Therefore, decisions that are made based on the net present value of an investment must allow a degree of flexibility to confront these potential changes, or risk.

Formula

Net present value is the sum of present values based on the cash flows of for a period of time, taking into consideration the following values:

t : the time of the cash flow

i : the discount rate

Rt : the net cash flow for the period of time specified (Cash Inflow – Cash Outflow)

R0 : the initial investment of the project/acquisition

Purpose

Net Present Value measures the present value of an investment based on assumptions of how the investment will perform in the future; projecting the value of an investment. The primary purpose of a business investment is to add long term value to the company. When a decision maker uses NPV to evaluate an investment, they are calculating whether or not that investment or acquisition will actually add long term value to the company. If NPV is greater than 0, it will add value and it is presumed the investment will add value. However, if NPV is less than 0 the investment won’t typically be made. In some cases the decision maker will disregard results of a negative NPV and will still move forward with the investment, but if this occurs it is likely that other factors are being considered and they bear more weight on the decision.

An example scenario of using net present value for decision making is as follows:

Soda Corp. wants to purchase a facility that will allow them to vertically integrate their production process (i.e. create a bottling manufacturing plant). When reviewing this potential acquisition they must know the cost of the facility (initial investment) and the cash flows over the predetermined period of time. Cash inflows could be a result of offering their bottling services to other soda companies and cash outflows will be operational expenses and other liabilities. They will also want to know their break-even point or the point in time where they recoup their initial expenses. The company’s decision maker will evaluate the results of their NPV as well as these other factors to determine if they should move forward with this investment.

Process

1.      Calculate annual cash flows for the particular project

2.      Divide each year’s cash flow by 1 + discount rate to the power of the respective year

3.      Add the results of step 2 to find their sum

4.      Subtract the initial investment- this is your NPV if >0 undertake otherwise forego

Caution

As briefly discussed, the results of NPV are subject to assumptions of future cash flows. To offset some of this risk, companies should establish contracts with both distributors and vendors to establish a degree of confidence that the company will be able to make purchases at a fixed cost for a period of time and that distributors will commit to specified level of product. This action will assist with adding stability to cash flow assumptions.

Conclusion

In short, NPV allows the decision maker to essentially compare present expenses and sales with future expenses and projected sales; and it should take all financial considerations into account for it to be effective. Additionally, while a positive value means the investment should be made because it will add value to the company, a negative value doesn’t necessarily mean the investment won’t be made as there are other factors that may outweigh the results of NPV.