What It Measures
Why It Is Important
Net present value helps management or potential investors weigh the wisdom of an investment—in new equipment, a new facility, or other type of asset—by enabling them to quantify the expected benefits. Those evaluating more than one potential investment can compare the respective projected returns to find the most attractive project.
A positive NPV indicates that the project should be profitable, assuming that the estimated cash flows are reasonably accurate. A negative NPV, of course, indicates that the project will probably be unprofitable and therefore should be adjusted, if not abandoned altogether.
Equally significantly, NPV enables a management to consider the time value of money it will invest. This concept holds that the value of money increases with time because it can always earn interest in a savings account. Therefore, any other investment of that money must be weighed against how the funds would perform if simply deposited and saved.
When the time value of money concept is incorporated in the calculation of NPV, the value of a project’s future net cash receipts in “today’s money” can be determined. This enables proper comparisons between different projects.
How It Works in Practice
Let’s say that Global Manufacturing Inc. is considering the acquisition of a new machine. First, its management would consider all the factors: Initial purchase and installation costs; additional revenues generated by sales of the new machine’s products; and the taxes on these new revenues. Having accounted for these factors in its calculations, the cash flows that Global Manufacturing projects will generate from the new machine are:
|Year 1||−$100,000 (initial cost of investment)|
At first glance, it appears that cash flows total a whopping 45% more than the $100,000 initial cost, a strikingly sound investment indeed.
Alas, it’s not that simple. Time value of money shrinks return on the project considerably, since future dollars are worth less than present dollars in hand. NPV accounts for these differences with the help of present value tables. These user-friendly tables, readily available on the internet and in references, list the ratios that express the present value of expected cash flow dollars, based on the applicable interest rate and the number of years in question.
In our example, Global Manufacturing’s cost of capital is 9%. Using this figure to find the corresponding ratios in the present value table, the $100,000 investment cost, and expected annual revenues during the five years in question, the NPV calculation looks like this:
|Year||Cash flow||Table factor (at 9%)||Present value|
|1||−$100,000||× 1.000000||= −$100,000.00|
|2||$30,000||× 0.917431||= $27,522.93|
|3||$40,000||× 0.841680||= $33,667.20|
|4||$40,000||× 0.772183||= $30,887.32|
|5||$35,000||× 0.708425||= $24,794.88|
Summing the present values of the cash flows and subtracting the investment cost from the total, the NPV is still positive. So, on this basis at least, the investment should proceed.
Tricks of the Trade
Beware of assumptions. Interest rates change, of course, which can affect NPV dramatically. Moreover, fresh revenues (as well as new markets) may not grow as projected. If the cash flows in years 2–5 of our example fall by $5,000 a year, for instance, NPV shrinks to $5,260.89, which is still positive but less attractive.
NPV calculations are performed only with cash receipts payments and discounting factors. In turn, NPV is a tool, not the tool. It ignores other accounting data, intangibles, sheer faith in a new idea, and other factors that may make an investment worth pursuing despite a negative NPV.
It is important to determine a company’s cost of capital accurately.