Asia Etrading Education Net Present Value
Net present value (NPV) is a standard method for evaluating competing long-term projects in capital budgeting. It measures the excess or shortfall of cash flows, in present value (PV) terms, once financing charges are met. All projects with a positive NPV should be undertaken.
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The discount rate
The interest rate used to discount future cash flows to their present values, is a key input of this process. Most firms have a well defined policy regarding their capital structure. So the weighted average cost of capital (after tax) is appropriate for use with all projects. Alternately, higher discount rates can be used for more risky projects. Another method is to apply higher discount rates to cash flows occurring further along the time span, to reflect the yield curve premium for long-term debt.
Alternative capital budgeting methods
* payback period : which measures the time required for the cash inflows to equal the original outlay. It measures risk, not return.
* cost-benefit analysis : which tries to include issues other than cash.
* real option method : which attempts to value managerial flexibility that is assumed away in NPV.
* internal rate of return (IRR): which calculates the rate of return of a project (that is predefined in NPV with the discount rate).
* Modified Internal Rate of Return - which in most, but not all, cases results in the same decision as NPV.
Reinvestment Rate
There are assumptions made about what rate of return is realized on cash that is freed-up before the end of the project. In the NPV model it is assumed to be reinvested at the discount rate used. This is appropriate in the absence of capital rationing. In the IRR model free cash is assumed reinvested at the IRR rate of the particular project.
Formula
Each cash inflow/outflow is discounted back to its PV. Then they are summed. For more information on how to calculate the PV of a dollar or of a stream of payments, go to Time value of money. In this formula t is the time of the cash flow, N the total time of the project, i the discount rate and C is the cash flow at that point in time.
Example
X corporation must decide whether to introduce a new product line. The new product will have startup costs, operational costs, and incoming cash flows over six years. This project will have an immediate (t=0) cash outflow of $100,000 (which might include machinery, and employee training costs). Other cash outflows for years 1-6 are expected to be $5,000 per year. Cash inflows are expected to be $30,000 per year for years 1-6. All cash flows are after-tax, and there are no cash flows expected after year 6. The required rate of return is 10%. The present value (PV) can be calculated for each year:
T=0 -$100,000 / 1.10^0 = -$100,000 PV.
T=1 ($30,000 - $5,000)/ 1.10^1 = $22,727 PV.
T=2 ($30,000 - $5,000)/ 1.10^2 = $20,661 PV.
T=3 ($30,000 - $5,000)/ 1.10^3 = $18,783 PV.
T=4 ($30,000 - $5,000)/ 1.10^4 = $17,075 PV.
T=5 ($30,000 - $5,000)/ 1.10^5 = $15,523 PV.
T=6 ($30,000 - $5,000)/ 1.10^6 = $14,112 PV.
The sum of all these present values is the net present value, which equals $8,882. Since the NPV is greater than zero, the corporation should invest in the project.
More realistic problems would need to consider other factors, generally including the calculation of taxes, uneven cash flows, and salvage values.
This article is licensed under the GNU Free Documentation License. It uses material from the Wikipedia article "Net Present Value "
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