The net present value is a mathematical formula that is being used by businesses for capital budgeting. In fact, it is considered as the most effective method to analyzing the profitability of a project or investment.
The net present value analysis is highly sensitive to future cash inflows that a project or investment will yield. In addition, this formula can be calculated using spreadsheets and tables.
The Net Present Value (NPV) compares the value of your money today to the value of the same amount of money in the future, taking the returns and inflation into account.
If the NPV of the project or investment is positive, this means that you should accept it. However, if the NPV is negative, you must reject the project because the cash flows will become negative too.
For example, if a furniture retail business wants to buy an existing store, the owner must estimate the cash flows that the store will generate in the future as well as the discount of the future cash flows into one present lump-sum or value amount like $600,000.
If the owner of that particular store is willing to sell the establishment in less than $600,000, you must purchase it as the NPV is positive.
However, if the furniture shop owner wants to sell the store above $600,000, you must not purchase the establishment as the investment presents negative NPV.
Investing in a project with negative NPV will reduce the value of the future cash flows that you will generate, and you will likely lose money in the long run.
Steps Involved in Calculating NPV
The NPV is a mathematical method for evaluating the investment of project proposals. This is a discounted cash flow calculation that enables you to predict the time value of your money. Below are lists of steps involved in calculating the NPV of the particular project.
• The investment of project future cash flows must be forecasted based on the realistic assumptions.
• Proper discount rates must be identified in order to discount the cash flows. The discount rates are the amount of projects initial capital, which must be equivalent to required return rates expected by the investors on equivalent risks of the investment.
• The current value of cash flows must be calculated using the project start-up capital, as the discount rate.
• The NPV’s must be derived by subtracting the present cash outflows value from the current value of cash inflows.
Net Present Value Project Acceptance Rule
It must be clear that you must only accept the project or investment if the NPV is positive, and reject the project if the NPV presents negative value.
Note that positive NPVs represent net wealth, and can increase the amount of future cash flows that the business will generate.
The positive NPV will only become a result of the calculation if the investment will generate cash inflows more than the opportunity cost of capital and cash outflows.
However, NPV with zero value may be accepted. A zero NPV implies that the particular investment has future cash flows that are equal to the rate of opportunity cost of capital.
Rules for project acceptance using NPV are as follows:
• You must accept the project if the net present value is positive.
• If the net present value implies negative result, reject the project.
• Accept the project if the NPV is zero; however, you may also reject it if you prefer so.
Net Present Value Limitations
The net present value is a theoretically realistic method. However, it may also pose computation problems. Below are lists of NPV limitations that may gain your interests.
• Estimation of Cash Flow: The NPV method is easy to use only if the forecasted cash flow is known. In frequent use, it is quite hard to obtain the cash flow estimates because of uncertainty.
• Mutual Exclusive Projects: You need to apply caution when using the method if the project or investment has underfunds constrained or unequal lives are being evaluated. In these situations, the NPV may not provide realistic results.
• Project Ranking: It must be noted that the project investment ranking as the NPV rule is not independent on the discount rate.
• Discount Rate: The NPV method can provide you with realistic cash flows, but difficult to process precise measures of discount rate.
The Importance of Net Present Value
The Net Present value is considered as the primary measure in investment profitability in all forms of business. It can provide you with acceptable investment rules. Below are the lists of the importance of NPV.
• Measures Profitability: The NPV uses the cash flows occurring over the entire lifespan of the investment or project by calculating its worth. Hence, this is considered as the true measure of investment profitability. This method relies on the estimated cash flows, and discount rates, rather than subjective consideration or arbitrary assumptions.
• Time Value: The NPV determine the time value of your money. The amount of money you receive today will have lucrative value in the future.
• Shareholder Value: The NPV is consistent with the shareholder’s value maximization.
• Additive Value: The NPV discounting process facilitates the measurement of cash flows in terms of existing values, which is in terms of equivalent, the current money. This means that the NPVs of the projects or investment can be added.
The Difference between Net Present Value (NPV) and Present Value (PV)
Net present value is the current value of inflows less the present value of the cash outflows. This means that the NPV can provide you with the realistic value of cash flows that will take over in the entire duration of the project investment.
The present value is the value of discounting future amounts in existence. This means that you can determine the future cash inflows, but does not include details about cash outflows.
In business, it is highly important that you predict the cash flows of investment to ensure that you’re earning. Therefore, using NPV method is a must in any forms of business.