Net Present Value (NPV) is a widely used term in investment banking and accounting. NPV is a useful financial analysis method for determining whether an investment or a project is profitable in the long run. The Net Present Value refers to the present value of future cash flows compared to current or initial investments.
Net Present Value: Meaning
Net present value refers to a capital budgeting tool that helps assess the profitability of an investment or a project. Businesses planning for expansion may need to make huge capital investments. For such businesses, capital budgeting tools as a popular NPV method prove to be beneficial. This enables them to understand whether an investment will become profitable.
NPV is determined by computing the negative cash flows, i.e., the costs and the positive cash flows, i.e., the gains for each period of an investment. After calculating the cash flow for each period, the present value of each is obtained by discounting its future value at a periodic rate of return. The NPV is calculated as the sum of all discounted future cash flows.
Net Present Value: How is it calculated?
The NPV can be calculated as the difference between the present value of cash inflows and the current value of cash outflows over a period.
NPV is calculated using the following formula:
NPV = Rt (1 + i)t
where,
t = time of cash flow
i = discount rate
Rt = net cash flow
In other words, net present value is the net off of the current value of cash inflows and outflows by discounting the flows at a specified rate. The rate is obtained by considering the return on investment with similar risk or cost of borrowing for the investment. The time value of money is taken into account. That is, it is based on the fact that a rupee today is of more value today than it will be tomorrow. Hence, net present value is crucial in ascertaining if a project is worth undertaking based on the present value of the cash flows.
The initial investment is deducted from the value after discounting the cash flows over different periods. A positive NPV means the project is accepted. In case of negative NPV, the project is declined. However, if NPV is zero, the business will remain indifferent.
Example:
Let us suppose a company plans to expand its business with an investment of Rs 10 lakh. It is expected to garner an inflow of Rs 1 lakh in the first year, Rs 2.5 lakh in the second year, Rs 3.5 lakh in the third year, Rs 2.65 lakh in the fourth year and Rs 4.15 lakh in the fifth year. The discount rate is taken as 9%.
The following NPV is based on the formula:
| Year | Flow | Present value | Computation |
| 0 | -10,00,000 | -10,00,000 | – |
| 1 | 1,00,000 | 91,743 | 1,00,000 / (1.09)1 |
| 2 | 2,50,000 | 2,10,419 | 2,50,000 / (1.09)2 |
| 3 | 3,50,000 | 2,70,264 | 3,50,000 / (1.09)3 |
| 4 | 2,65,000 | 1,87,732 | 2,65,000 / (1.09)4 |
| 5 | 4,15,000 | 2,69,721 | 415000 / (1.09)5 |
The total of present value of cash inflows for all five years is Rs 10,29,879. The initial investment is Rs 10,00,000. Hence, the NPV is Rs 29879. The investment will be profitable as NPV is positive.
See also: Drawdown: Meaning, significance and examples
Net Present Value: Advantages
Used for comprehensive analysis
The net present value is a comprehensive tool that considers all aspects, such as inflows, outflows, period of time and risks involved in a project or investment.
Time value of money
The NPV method is used for assessing the profitability of a project. It takes the time value of money into account. The future cash flows will be of lesser value than the cash flows of today. Thus, the further the cash flows, lesser will the value. It helps in comparing two similar projects for any business. If Project A has a life of three years with higher cash flows in the initial period and Project B has a life of three years with higher cash flows in the latter period, by applying NPV, Project A can be chosen as inflows today are more valued than inflows in future.
Value of investment
In addition to determining if a project or an investment will be profitable or not, the NPV method provides the value of total profits. It quantifies the gains or losses from the investment. The value obtained after calculation (Rs 29879 in the above example), shows that the project will gain after discounting the cash flows.
Net Present Value: Disadvantages
Discounting rate
In net present value method, the rate of return must be determined, which is one of the limitations of this method. In case a higher rate of return is presumed, the calculations may reflect a false negative NPV. Likewise, a lower rate of return may reflect a false projection that the project will be profitable and lead to incorrect decisions.
Multiple assumptions
The net present value method is used to make several assumptions in terms of inflows, outflows, etc. Some expenditures may be seen only when the project takes off in reality. Further, the inflows may not be the same as the projections made. Today, the NPV analysis is done using software to support management decision-making.
Different projects are not comparable
The NPV may not be used for comparing two projects that do not belong to the same period. Several businesses have a fixed budget and may have two project options. In some cases, this method may not be helpful for comparing two projects differing in a period of time or risks involved in the projects.
NPV Calculator: How does it work?
The NPV calculator is a useful tool that helps calculate the NPV of a project or investment and shows the value of an investment at present. It takes into consideration various aspects such as the expenses, revenue and capital costs to ascertain the profitability of an investment or a project. Start by projecting your cash flows on a net basis.
- Input your initial investment amount.
- In the next step, input the discount rate, which is the rate of interest used to discount all future cash flows of an investment.
- Provide the number of years of investment.
- Choose the type of cash inflows – fixed or variable and provide the cash flow for each year.
The NPV is computed based on the values entered.
FAQs
What is the actual net present value?
Net present value is a reflection of how much a project or an investment is worth in its lifetime, discounted to today's value.
What is a good NPV?
A project or an investment is considered to be profitable if the NPV is positive.
Why should net present value be used?
The net present value is a comprehensive method that takes into account all aspects, such as inflows, outflows, period of time and risks involved in a project or investment. It helps determine whether an investment or a project will be profitable in the long run.
Can NPV be negative?
NPV can be negative, which indicates the project or investment will not be profitable.
What if the NPV is zero?
If the NPV is zero, the rate of return earned on the investment is equal to the discount rate.
What if NPV is greater than zero?
A positive NPV indicates that the investment or project is profitable.
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