Financial Accounting

Net Present Value: Investment Appraisal Tool

What is the Net Present Value Method?

Net present value is the total value of the expected future cash flows for a project or investment and deducts a return that the cash is expected to earn.

Net Present Value (NPV) is one of the most used techniques of capital investment appraisal.

Net Present Value Explained

The net present value of a future stream of cash flows is the amount of cash it would take to provide investors a guaranteed, safe return on their investment at the given interest rate.

In plain English, you calculate the total amount of money you would have to put out of your pocket right now in order to receive a return of X%, and add up the total. If it’s a good investment, it should make money. If it’s a bad investment, it should lose money.

Under this method, the initial investment is compared to discounted revenues. Under another approach, the sum of all cash flows is compared to the sum of all cash inflows. Both the inflows and outflows are discounted using a cut-off rate or desired rate of interest.

Example of Net Present Value Calculation

For example, if a machine is purchased in the year 2019 for $10,000. It would be considered as cash outflow. Now, let’s say net cash flows arising from this investment are $3,000 in 2020, $5,000 in 2021 and $4,000 in the year 2022. Here the simple sum of outflows is $3,000+5,000+4,000 = $12,000. It seems that investment has positive cash flows of $2,000. However, it is not the case. The above-mentioned cash flows are non-discounted. After discounting the scenario might change.

Let’s say the desired rate of interest is 10%. Now the discounted values will become $2727.27, 4132.23 and 3005.26 and the sum of discounted cash flows will be 9,864.76, which is lesser than the initial investment and makes the investment non-feasible.

However, if the required rate of return is lesser than 10%, say 6% or 7% it still might be a good investment.

Decision Criteria: A project should be accepted if the net present value of the project is positive or more than zero. If NPV is 0 or negative it should be rejected.

A five-step approach can be utilized to compute the NPV:

  1. Determine the cost of the project
  2. Estimate the project’s future cash flows over its forecasted life
  3. Determine the riskiness of the project and estimate the appropriate cost of capital
  4. Compute the project’s NPV
  5. Make a decision

 

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