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NetPresentValue(NPV)Definition|Calculation|Examples

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NetPresentValue(NPV)

Netpresentvalue(NPV)ofaprojectisthepotentialchangeinaninvestor'swealthcausedbythatprojectwhiletimevalueofmoneyisbeingaccounted
for.Itequalsthepresentvalueofnetcashinflowsgeneratedbyaprojectlesstheinitialinvestmentontheproject.Itisoneofthemostreliable
measuresusedincapitalbudgetingbecauseitaccountsfortimevalueofmoneybyusingdiscountedcashflowsinthecalculation.
Netpresentvaluecalculationstakethefollowingtwoinputs:
Projectednetcashflowsinsuccessiveperiodsfromtheproject.
Atargetrateofreturni.e.thehurdlerate.
Where,
Netcashflowequalstotalcashinflowduringaperiod,includingsalvagevalueifany,lesscashoutflowsfromtheprojectduringtheperiod.
Hurdlerateistherateusedtodiscountthenetcashinflows.Weightedaveragecostofcapital(WACC)isthemostcommonlyusedhurdlerate.

CalculationMethodsandFormulas
ThefirststepinvolvedinthecalculationofNPVistheestimationofnetcashflowsfromtheprojectoveritslife.Thesecondstepistodiscountthose
cashflowsatthehurdlerate.
Thenetcashflowsmaybeeven(i.e.equalcashflowsindifferentperiods)oruneven(i.e.differentcashflowsindifferentperiods).Whentheyareeven,
presentvaluecanbeeasilycalculatedbyusingtheformulaforpresentvalueofannuity.However,iftheyareuneven,weneedtocalculatethepresent
valueofeachindividualnetcashinflowseparately.
Oncewehavethetotalpresentvalueofallprojectcashflows,wesubtracttheinitialinvestmentontheprojectfromthetotalpresentvalueofinflows
toarriveatnetpresentvalue.
ThuswehavethefollowingtwoformulasforthecalculationofNPV:
Whencashinflowsareeven:

NPV=R

1(1+i)n

InitialInvestment

Intheaboveformula,
Risthenetcashinflowexpectedtobereceivedineachperiod
iistherequiredrateofreturnperperiod
narethenumberofperiodsduringwhichtheprojectisexpectedtooperateandgeneratecashinflows.
Whencashinflowsareuneven:

NPV=

R1
(1+i)1

R2
(1+i)2

R3
(1+i)3

+...

InitialInvestment

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9/2/2015

NetPresentValue(NPV)Definition|Calculation|Examples

Where,
iisthetargetrateofreturnperperiod
R1isthenetcashinflowduringthefirstperiod
R2isthenetcashinflowduringthesecondperiod
R3isthenetcashinflowduringthethirdperiod,andsoon...

DecisionRule
Incaseofstandaloneprojects,acceptaprojectonlyifitsNPVispositive,rejectitifitsNPVisnegativeandstayindifferentbetweenacceptingor
rejectingifNPViszero.
Incaseofmutuallyexclusiveprojects(i.e.competingprojects),accepttheprojectwithhigherNPV.

Examples
Example1:EvenCashInflows:Calculatethenetpresentvalueofaprojectwhichrequiresaninitialinvestmentof$243,000anditisexpectedto
generateacashinflowof$50,000eachmonthfor12months.Assumethatthesalvagevalueoftheprojectiszero.Thetargetrateofreturnis12%
perannum.
Solution
Wehave,
InitialInvestment=$243,000
NetCashInflowperPeriod=$50,000
NumberofPeriods=12
DiscountRateperPeriod=12%12=1%
NetPresentValue
=$50,000(1(1+1%)^12)1%$243,000
=$50,000(11.01^12)0.01$243,000
$50,000(10.887449)0.01$243,000
$50,0000.1125510.01$243,000
$50,00011.2551$243,000
$562,754$243,000
$319,754
Example2:UnevenCashInflows:Aninitialinvestmentof$8,320thousandonplantandmachineryisexpectedtogeneratecashinflowsof$3,411
thousand,$4,070thousand,$5,824thousandand$2,065thousandattheendoffirst,second,thirdandfourthyearrespectively.Attheendofthe
fourthyear,themachinerywillbesoldfor$900thousand.Calculatethenetpresentvalueoftheinvestmentifthediscountrateis18%.Roundyour
answertonearestthousanddollars.
Solution
PVFactors:
Year1=1(1+18%)^10.8475
Year2=1(1+18%)^20.7182
Year3=1(1+18%)^30.6086
Year4=1(1+18%)^40.5158
Therestofthecalculationissummarizedbelow:
Year
NetCashInflow

$3,411

$4,070

$5,824

$2,065

$3,411

$4,070

$5,824

$2,965

SalvageValue
TotalCashInflow
PresentValueFactor
PresentValueofCashFlows

900
0.8475

0.7182

0.6086

0.5158

$2,890.68

$2,923.01

$3,544.67

$1,529.31

TotalPVofCashInflows

$10,888

InitialInvestment

8,320

NetPresentValue

$2,568 thousand

StrengthsandWeaknessesofNPV
Strengths
Netpresentvalueaccountsfortimevalueofmoneywhichmakesitasounderapproachthanotherinvestmentappraisaltechniqueswhichdonot
discountfuturecashflowssuchpaybackperiodandaccountingrateofreturn.
NetpresentvalueisevenbetterthansomeotherdiscountedcashflowstechniquessuchasIRR.InsituationswhereIRRandNPVgiveconflicting
decisions,NPVdecisionshouldbepreferred.

Weaknesses
NPVisafterallanestimation.Itissensitivetochangesinestimatesforfuturecashflows,salvagevalueandthecostofcapital.

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NetPresentValue(NPV)Definition|Calculation|Examples

Netpresentvaluedoesnottakeintoaccountthesizeoftheproject.Forexample,sayProjectArequiresinitialinvestmentof$4milliontogenerateNPV
of$1millionwhileacompetingProjectBrequires$2millioninvestmenttogenerateanNPVof$0.8million.IfwebaseourdecisiononNPValone,we
willpreferProjectAbecauseithashigherNPV,butProjectBhasgeneratedmoreshareholderswealthperdollarofinitialinvestment($0.8million/$2
millionvs$1million/$4million).
WrittenbyIrfanullahJan

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