Net Present Value (NPV) is a measure that estimates the expected profitability of a project based on its forecasted cash flow stream and the initial cost of such project. A positive Net Present Value (NPV) indicates that the project, considering the time value of money, covers the initial investment and can be therefore accepted by the company as it will add value to it.
What is Net Present Value?
Contents
The NPV model is widely employed by investors and managers in order to estimate if a project adds value to the business, considering its future cash flows and the firm’s cost of capital. The main concept that supports the efficacy of the NPV calculation is the time value of money. This theory states that any money produced in the future has to be discounted to its present value by a discount rate, which is understood as the opportunity cost of not investing those funds or the minimum cost of capital of the business or the investor’s cost of capital.
The model is commonly employ for the purpose of capital budgeting, as companies often have a certain number of projects they have to evaluate, to choose the most profitable ones. By employing the NPV, a company can select all projects with an NPV equal or higher than zero, as long as it has resources to take them all.
Net Present Value Formula
The net present value formula for a project or investment is calculated like this:
NPV = IC + CF1 * (1 + r)^1 + CF2 * (1 + r)^2 + CF3 * (1 + r)^3… CFn * (1 + r)^n
Net Present Value Equation Components
IC = Initial cost or Initial investment, which includes the total amount paid at the beginning of the project to set it in motion.
CF = The amount of cash flow generated on each time period.
r = The discount rate at which the cash flow’s present value is estimated.
n = the time period at which the cash flow occurs.
The result will be a positive or negative amount that will indicate the project’s profitability.
Net Present Value Calculation Example
American Gateways is a company that manufactures wooden doors for many different types of constructions. The company is currently analyzing a project that involve expanding one of its current production facilities to host a significant new number of production lines.
The project’s estimated initial cost is $23,452,000 and the useful life of the new lines is estimated to be around 10 years. The company has also estimate that the project will generate for year 1 a positive cash flow of $1,811,000 and this amount will increase by an average of 3% per year. The company’s Weighted Average Cost of Capital is 8.7%
By using this information, the Finance Department can estimate the Net Present Value of the project, as follows:
NPV = $23,452,000 + $1,811,000 * (1 + 0.087)^1 + (1,811,000 * (1,03^2)) * (1 + 0.087)^2 + (1,811,000 * (1,03^3)) * (1 + 0.087)^3… (1,811,000 * (1,03^10)) * (1 + 0.087)^10
As a result, the NPV for this project would be – $4,352,565. This means the new production lines are not as profitable as the management team initially thought, as the NPV of the project is negative. In this case, the company must find a way to either reduce the initial cost, increase the future cash flows or reduce the WACC in order to bring the NPV up to 0 at least.
Net Present Value Calculator Analysis
The Net Present Value formula is highly useful for capital budgeting as it allows managers to compare projects based on their capacity to add value to the firm. An investment can’t be evaluated based solely on its profitability, as the amount invested varies. For this reason, the NPV provides an adequate approach that includes both the present value of the cash flows that will be received from the investment and also the initial cost of the investment.
The importance of the discount rate lies on the fact that a cash flow produced 3 years from now has a lower value than a cash flow earned today. This is the effect of the time value of money, which decreases as time passes, due to the lost income from not investing that cash flow in other potential investment opportunities. The NPV incorporates this element into the analysis in order to determine how much the cash flows actually contribute to the project depending on the moment when they occur.
An NPV equal to 0 or higher means that the project’s discounted cash flows cover the initial cost (if NPV equal 0) or exceeds it (if NPV higher than 0). If this is the case, the project can be accepted by the company, knowing that it will add value to the business. On the other hand, a project with a negative NPV indicates that the discounted cash flows are insufficient, as the sum of all of them results in an amount lower than the initial cost of the investment.
A company that has to evaluate a pool constituted by different projects will first calculate their NPV individually. Any project with an NPV equal or higher than 0 must be shortlisted, and after determining the budget available for such projects, the company should execute the projects with the higher NPV progressively until the budget is fully covered.
Net Present Value Uses, Cautions, Pitfalls
It is important to consider that the NPV measures a project’s profitability in absolute terms. This means that for the purpose of comparing one project to another, large projects will potentially produce larger absolute NPV values, even though they may not be the most profitable in relative terms.
For this reason, some analysts compare projects based on their Return on Investment (ROI), based on the NPV’s data. In order to do so, they discount the positive cash flows and then the formula for the ROI looks like this:
ROI = (Discounted Cash Flows – Initial Cost of Project) / Initial Cost of Project
The result is a percentage of return that may serve as a more accurate metric to compare one project to the other, as it allows the analyst to evaluate projects of different sizes.