The difference between the present cash value and the value of cash outflows at present will give you the net present value. Net present value is one of the most important and the most popular methods of analyzing the profitability associated with any project or investment. It is an important part of capital budgeting.
Formula
The formula for calculating the net present value is:
NPV = ∑ {Ct/(1+R)^t} – Co
Where:
Co = total cost of the initial investment costs
Ct = net cash inflow during the period t
t = number of time periods, and
r = discount rate
Positive and Negative Net Present Values
If you get a positive net present value for a project, it means that the earnings from the project exceed the total anticipated cost that will be invested in the project over time in dollars. Generally, if the net present value for a project comes out to be positive, it is likely to be profitable. On the other hand, if the net present value comes out to be negative for a project, the investment will result in a net loss. Hence, it is advisable that you only go ahead with the projects that have a positive net present value.
Apart from the formula, you can also use spreadsheets and tables to calculate the net present value.
Alternatives and Drawbacks
NPV basically relies on a number of estimates and assumptions; hence, there is a substantial room for error in the calculations and thus the final judgment made on it. The factors that are estimated in calculating the net present value include the discount rate, the investment cost and the projected returns.
The risk associated with the project may also not be accounted for in the net present value. Because of the lack of proper risk assessment, the cash flows may be assumed to be maximum, when in reality, the cash flows may not be as much as calculated by the NPV.
One of the most famous alternatives of NPV is the payback period. It is basically the time required by the investment to give you back the money you invested initially in the project. The time value of the money, however, is not calculated by the payback period; hence, it has a high chance of inaccuracy when it comes to longer investments. It also fails to account for the profitability associated with the project.
Further Reading
- The variable financial indicator IRR and the constant economic indicator NPV – www.tandfonline.com [PDF]
- Free Cash Flow (FCF), Economic Value Added (EVA™), and Net Present Value (NPV):. A Reconciliation of Variations of Discounted-Cash-Flow (DCF) Valuation – www.tandfonline.com [PDF]
- A resolution to the NPV–IRR debate? – www.sciencedirect.com [PDF]
- Why the NPV criterion does not maximize NPV – academic.oup.com [PDF]
- NPV approach to material requirements planning theory–a 50-year review of these research achievements – www.tandfonline.com [PDF]
- Decoupled NPV: a simple, improved method to value infrastructure investments – www.tandfonline.com [PDF]
- The IRR, NPV and the fallacy of the reinvestment rate assumptions – www.tandfonline.com [PDF]
- A better understanding of why NPV undervalues managerial flexibility – www.tandfonline.com [PDF]
- Investment decisions and sensitivity analysis: NPV-consistency of rates of return – www.sciencedirect.com [PDF]
