Companies often use net present value (NPV) as a method for capital budgeting because it may be the most detailed and useful method for assessing whether to invest in a new capital project. It is more sophisticated in terms of the mathematics and time value of money than the payback period and discounted payback period methods. It is also more detailed in certain ways than the profitability index or internal rate of return calculation.
What is Net Present Value (NPV)?
Net present value is one of several capital budgeting methods used to evaluate potential physical asset projects that a company may want to invest in. These capital investment projects are typically large in scope and money, such as purchasing an expensive set of production line equipment or building a new facility.
Net present value uses discounted cash flows in the analysis, making the net present value more accurate than any of the other capital budgeting methods because it considers both risk-related and time-related variables.
An NPV analysis involves several variables and assumptions and assesses the cash flows expected to be delivered by a project by discounting them to present value using information that includes the project duration (t) and the company’s weighted average cost of capital (i). If the result is positive, the company should invest in the project. If it is negative, the company should not invest in the project.
Capital Projects Using Net Present Value
Before you can use net present value to evaluate a capital investment project, you need to determine whether the project is mutually exclusive or independent. Independent projects are those that are not affected by cash flows from other projects.
Mutually exclusive projects, however, are different. If there are mutually exclusive projects, it means that there are two options to achieve the same result. It may be the case that the business has solicited bids for a project and received several proposals. It does not want to accept two bids for the same project, so it will accept the one with the highest net present value, automatically rejecting the others. This is an example of a mutually exclusive project.
When evaluating two capital investment projects, you should assess whether they are independent or mutually exclusive and make a decision to accept or reject based on that consideration.
Net Present Value Decision Rules
Every capital budgeting method has a set of decision rules. For example, the decision rule for the payback period method is that you accept the project if it recovers its initial investment within a specified timeframe. The same rule applies to the discounted payback period method.
Net present value also has its own decision rules, which include the following: Independent projects: If the net present value is greater than 0, accept the project. Mutually exclusive projects: If the net present value of one project is greater than that of another project, accept the project with the higher net present value. If both projects have a negative net present value, reject both projects.
Example: Calculating Net Present Value
Suppose XYZ Inc. is considering two projects, Project A and Project B, and wants to calculate the net present value for each project. Project A is a four-year project with cash flows in each of the four years: $5,000, $4,000, $3,000, and $1,000. Project B is also a four-year project with cash flows in each of the four years: $1,000, $3,000, $4,000, and $6,750. The company’s cost of capital is 10 percent for each project, and the initial investment is $10,000.
It wants
The company is in the process of determining and comparing the net present value of these cash flows for both projects. Each project has unequal cash flows. In other words, the cash flows are not terminal.
Below is the basic equation for calculating the present value of cash flows, NPV (p), when cash flows vary in each period:
NPV (p) = CF (0) + CF (1) / (1 + i) t + CF (2) / (1 + i) t + CF (3) / (1 + i) t + CF (4) / (1 + i) t
Where: i = the cost of capital for the company t = the year in which the cash flow is received CF (0) = the initial investment
To work with the present value of the net: add the cash flow from year 0, which is the initial investment in the project, to the rest of the cash flows for the project. The initial investment is an outflow, thus it is a negative number. In this example, the cash flows for each project for years 1 to 4 are all positive figures.
To calculate the present value of project A:
NPV (A) = (-10,000 dollars) + 5,000 dollars / (1.10) 1 + 4,000 dollars / (1.10) 2 + 3,000 dollars / (1.10) 3 + 1,000 dollars / (1.10) 4
= 788.20 dollars
The net present value of project A is 788.20 dollars, meaning that if the company invests in the project, it adds 788.20 dollars to the company’s value.
Disadvantages of Net Present Value
Although net present value provides insight and a useful method for estimating the value of a project and its potential contribution to profit, it has its drawbacks. Since no analyst has a crystal ball, every capital budgeting method suffers from the risk of estimating critical parameters for the formula and assumptions, in addition to unforeseen or unexpected events that could impact project costs and cash flows.
The calculation of net present value relies on estimated costs and an estimated discount rate and projected project return. It may also not take into account unexpected expenses, time delays, and any other problems that arise at the front or back end, or during the project.
Additionally, the discount rate and cash flows used in the calculation of net present value often do not capture all potential risks, instead assuming peak values for cash flows for each period of the project. This leads to a false sense of confidence for investors, and companies often run different scenarios for net present value using conservative, aggressive, and more likely portfolio combinations to help mitigate this risk.
Alternative Valuation Methods
In some cases, especially for short-term projects, simpler valuation methods are appropriate. The payback period method calculates the amount of time it will take to recover the initial investment of the project. While it does not consider profits that come after the initial costs have been recouped, the decision-making process may not require this component of analysis. The method does not take into account the time value of money, making it less effective for long-term projects or in inflationary environments.
Internal Rate of Return (IRR) analysis is another option frequently used, although it relies on the same formula as net present value. IRR analysis differs in that it only considers cash flows for each period and ignores the initial investment. Additionally, the result is obtained by solving for the discount rate, rather than inputting an estimated rate as is done with the net present value formula.
Result
The internal rate of return formula is annualized, making it easy to compare different projects. The formula for net present value, on the other hand, produces a result that takes into account all the years of the project together, whether it is one year, three years, or more, making it difficult to compare with other projects that have different timelines.
Source: https://www.thebalancemoney.com/net-present-value-npv-as-a-capital-budgeting-method-392915
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