Net present value

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In finance, the net present value (NPV) or net present worth (NPW)[1] of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values (PVs) of the individual cash flows. In the case when all future cash flows are incoming (such as coupons and principal of a bond) and the only outflow of cash is the purchase price, the NPV is simply the PV of future cash flows minus the purchase price (which is its own PV). NPV is a central tool in discounted cash flow (DCF) analysis, and is a standard method for using the time value of money to appraise long-term projects. Used for capital budgeting, and widely throughout economics, finance, and accounting, it measures the excess or shortfall of cash flows, in present value terms, once financing charges are met. The NPV of a sequence of cash flows takes as input the cash flows and a discount rate or discount curve and outputs a price; the converse process in DCF analysis - taking a sequence of cash flows and a price as input and inferring as output a discount rate (the discount rate which would yield the given price as NPV) - is called the yield, and is more widely used in bond trading.

Contents
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1 Formula 2 The discount rate 3 NPV in decision making 4 Example 5 Common pitfalls 6 History 7 Alternative capital budgeting methods 8 References

Formula
Each cash inflow/outflow is discounted back to its present value (PV). Then they are summed. Therefore NPV is the sum of all terms,

where t - the time of the cash flow

i - the discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.)

Rt - the net cash flow (the amount of cash, inflow minus outflow) at time t. For educational purposes, R0 is
commonly placed to the left of the sum to emphasize its role as (minus) the investment. The result of this formula if multiplied with the Annual Net cash in-flows and reduced by Initial Cash outlay will be the present value but in case where the cash flows are not equal in amount then the previous formula will be used to determine the present value of each cash flow separately. Any cash flow within 12 months will not be discounted for NPV purpose.[2]

The discount rate

Main article: Discount rate The rate used to discount future cash flows to the present value is a key variable of this process. A firm's weighted average cost of capital (after tax) is often used, but many people believe that it is appropriate to use higher discount rates to adjust for risk or other factors. A variable discount rate with higher rates applied to cash flows occurring further along the time span might be used to reflect the yield curve premium for long-term debt. Another approach to choosing the discount rate factor is to decide the rate which the capital needed for the project could return if invested in an alternative venture. If, for example, the capital required for Project A can earn five percent elsewhere, use this discount rate in the NPV calculation to allow a direct comparison to be made between Project A and the alternative. Related to this concept is to use the firm's Reinvestment Rate. Reinvestment rate can be defined as the rate of return for the firm's investments on average. When analyzing projects in a capital constrained environment, it may be appropriate to use the reinvestment rate rather than the firm's weighted average cost of capital as the discount factor. It reflects opportunity cost of investment, rather than the possibly lower cost of capital. An NPV calculated using variable discount rates (if they are known for the duration of the investment) better reflects the real situation than one calculated from a constant discount rate for the entire investment duration. Refer to the tutorial article written by Samuel Baker[3] for more detailed relationship between the NPV value and the discount rate. For some professional investors, their investment funds are committed to target a specified rate of return. In such cases, that rate of return should be selected as the discount rate for the NPV calculation. In this way, a direct comparison can be made between the profitability of the project and the desired rate of return.

To some extent, the selection of the discount rate is dependent on the use to which it will be put. If the intent is simply to determine whether a project will add value to the company, using the firm's weighted average cost of capital may be appropriate. If trying to decide between alternative investments in order to maximize the value of the firm, the corporate reinvestment rate would probably be a better choice. Using variable rates over time, or discounting "guaranteed" cash flows differently from "at risk" cash flows may be a superior methodology, but is seldom used in practice. Using the discount rate to adjust for risk is often difficult to do in practice (especially internationally), and is difficult to do well. An alternative to using discount factor to adjust for risk is to explicitly correct the cash flows for the risk elements using rNPV or a similar method, then discount at the firm's rate.

NPV in decision making

NPV is an indicator of how much value an investment or project adds to the firm. With a particular project, if Rt is a positive value, the project is in the status of discounted cash inflow in the time of t. If Rt is a negative value, the project is in the status of discounted cash outflow in the time of t. Appropriately risked projects with a positive NPV could be accepted. This does not necessarily mean that they should be undertaken since NPV at the cost of capital may not account for opportunity cost, i.e. comparison with other available investments. In financial theory, if there is a choice between two mutually exclusive alternatives, the one yielding the higher NPV should be selected.

If...

It means...

Then...

the investment NPV would add value to the project may be accepted >0 the firm the investment NPV would subtract value the project should be rejected <0 from the firm the investment NPV would neither gain =0 nor lose value for the firm We should be indifferent in the decision whether to accept or reject the project. This project adds no monetary value. Decision should be based on other criteria, e.g. strategic positioning or other factors not explicitly included in the calculation.

Example
A 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 16 are expected to be $5,000 per year. Cash

inflows are expected to be $30,000 each for years 16. 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:

Yea r T=0

Cash flow

Present value -$100,000

T=1

$22,727

T=2

$20,661

T=3

$18,783

T=4

$17,075

T=5

$15,523

T=6

$14,112

The sum of all these present values is the net present value, which equals $8,881.52. Since the NPV is greater than zero, it would be better to invest in the project than to do nothing, and the corporation should invest in this project if there is no mutually exclusive alternative with a higher NPV. The same example in Excel formulae:

NPV(rate,net_inflow)+initial_investment PV(rate,year_number,yearly_net_inflow)

More realistic problems would need to consider other factors, generally including the calculation of taxes, uneven cash flows, and Terminal Value as well as the availability of alternate investment opportunities.

Common pitfalls

If, for example, the Rt are generally negative late in the project (e.g., an industrial

or mining project might have clean-up and restoration costs), then at that stage the company owes money, so a high discount rate is not cautious but too optimistic. Some people see this as a problem with NPV. A way to avoid this problem is to include explicit provision for financing any losses after the initial investment, that is, explicitly calculate the cost of financing such losses.

Another common pitfall is to adjust for risk by adding a premium to the discount

rate. Whilst a bank might charge a higher rate of interest for a risky project, that does not mean that this is a valid approach to adjusting a net present value for risk, although it can be a reasonable approximation in some specific cases. One reason such an approach may not work well can be seen from the following: if some risk is incurred resulting in some losses, then a discount rate in the NPV will reduce the impact of such losses below their true financial cost. A rigorous approach to risk requires identifying and valuing risks explicitly,e.g. by actuarial or Monte Carlo techniques, and explicitly calculating the cost of financing any losses incurred.

Yet another issue can result from the compounding of the risk premium. R is a

composite of the risk free rate and the risk premium. As a result, future cash flows are discounted by both the risk-free rate as well as the risk premium and this effect is compounded by each subsequent cash flow. This compounding results in a much lower NPV than might be otherwise calculated. The certainty equivalent model can be used to account for the risk premium without compounding its effect on present value.[citation needed]

Another issue with relying on NPV is that it does not provide an overall picture of

the gain or loss of executing a certain project. To see a percentage gain relative to the investments for the project, usually,Internal rate of return or other efficiency measures are used as a complement to NPV.

History

Net present value as a valuation methodology dates at least to the 19th century. Karl Marx refers to NPV as fictitious capital, and the calculation as capitalising, writing:[4]

The forming of a fictitious capital is called capitalising. Every periodically repeated income is capitalised by calculating it on the average rate of interest, as an income which would be realised by a capital at this rate of interest.
In mainstream neo-classical economics, NPV was formalized and popularized by Irving Fisher, in his 1907 The Rate of Interest and became included in textbooks from the 1950s onwards, starting in finance texts.[5][6]

Alternative capital budgeting methods

Adjusted present value (APV): adjusted present value, is the net present value of

a project if financed solely by ownership equity plus the present value of all the benefits of financing.

savings.

Accounting rate of return (ARR): a ratio similar to IRR and MIRR Cost-benefit analysis: which includes issues other than cash, such as time

Internal rate of return: which calculates the rate of return of a project while

disregarding the absolute amount of money to be gained.

Modified internal rate of return (MIRR): similar to IRR, but it makes explicit

assumptions about the reinvestment of the cash flows. Sometimes it is called Growth Rate of Return.

Payback period: which measures the time required for the cash inflows to equal

the original outlay. It measures risk, not return.

Real option method: which attempts to value managerial flexibility that is

assumed away in NPV.

NPV Ambiguity
Net present value is used in two different contexts in finance. The term NPV may be referred to as net present worth of series of payments or receipts such as in case of an annuity. The second term refers to the net present value for a series of net cash flows that have an outgoing cash expense at the beginning of the cash streams. This latter definition provides an investor with insights in to the financial viability of an investment such as replacement decision, extension of products and services.

NPV Formula for an annuity

The first of these formula is for finding NPV of an ordinary annuity where payments or receipts are expected at the end of the period. An example of this type of receipt would be a payment from a pension fund at the end of each month or a payment for a home mortgage at the end of each month or quarter.

Here we discount each of the amounts of the annuity with the interest rate, the time period starts at 1 and ends at n the last period at which the annuity receipt or payment is due.

NPV Formula for an annuity due

The second of these formula is for an annuity due where payments or receipts are expected at the start of the period. An example of this would be monthly housing rent payment or lease payment for machinery.

Here each payment or receipt is discounted at interest rate i for time period t-1

NPV Example for an annuity

We will illustrate finding net present value of an ordinary annuity by showing you detailed calculation for a hypothetical lottery prize winner who has won 20 million dollars. The state authorities has offered the prize winner two options. The first option is to accept an annual payment of one million dollar for each of the next twenty years starting at the end of this current year. The second option is to take a lump sum payment of 12 million dollars on the spot.

NPV calculation for an annuity

So how would the prize winner decide whether to accept a lump sum payment or to accept annual receipts of one million dollars for the next twenty years. We will show you how the prize winner can make his choice. The winner has to first determine his or her opportunity cost which may be the interest rate offered by a local bank for opening a savings account. Thus the interest rate is taken as the winners opportunity cost that he or she is willing to let go when accepting a lump sum payment. Let us assume an interest rate of 12% compounded annually, see the following table of values that shows the schedule for present value of one million dollars over the next twenty years discounted at 12%. If the net present value of this sum is less than 12 million dollars then the winner is better off taking the lump sum payment of 12 million dollars instead of an annual payment of one million dollars over the next twenty years

Net Present Value of an annuity at 12%

Year 1 2 3 Annual Payment $1,000,000 $1,000,000 $1,000,000 PVIF @ 12% 0.893 0.797 0.712 Present Value $893,000 $797,000 $712,000

4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

$1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000

0.636 0.567 0.507 0.452 0.404 0.361 0.322 0.287 0.257 0.229 0.205 0.183 0.163 0.146 0.130 0.116 0.104 NPV

$636,000 $567,000 $507,000 $452,000 $404,000 $361,000 $322,000 $287,000 $257,000 $229,000 $205,000 $183,000 $163,000 $146,000 $130,000 $116,000 $104,000 $7,471,000

Lottery Winner's Choice

As the calculation show that one million dollars paid each year over the next twenty years when discounted at 12% are worth only seven and half million dollars today. Thus the prize winner is better off selecting a lump sum payment of twelve million dollars instead.

NPV for pensions, loans and savings

The process I just explained in the preceeding paragraphs applies equally to finding NPV or net present value for pensions, loans and savings since all these are sort of annuities either with constant or uneven payments and/or receipts. You can layout the pension payments as a series of tabular data, and use the PVIF or interest factor for discounting each of these amounts to find the discounted amount. The sum of these discounted amounts will be the net present value or NPV of such a loan, savings or pension fund.

NPV method in DCF Analysis

NPV or net present value is a discounted cash flow method that is defined as the difference between discounted benefits and discounted costs associated with a project. A positive NPV value is acceptable where as an NPV of zero yields the internal rate of return. A negative value for NPV suggests that investment is not worthy of the money we are about to invest.

NPV Formula

You may visit this page that explains NPV Formula and NPV Equation in detail

NPV Example
Let us examine finding Net Present Value or NPV with an example investment proposal. Let us say we were offered a series of cash inflows at the end of each of the next four years as $5000, $4000, $3000, and $1000. And the initial cash outlay for this proposal is $10,000 and weighted average cost of capital orWACC is 12%.

NPV at 12%

Year 1 2 3 4

Net Cash Flows 5000 4000 3000 1000

PVIF @ 12% 0.893 0.797 0.712 0.636 NPV = $425

Present Value $4,465 $3,188 $2,136 $636 $10,425-10,000

NPV at 15%
Year 1 2 3 4 Net Cash Flows 5000 4000 3000 1000 PVIF @ 15% 0.870 0.756 0.658 0.572 NPV =-$80 Present Value $4,350 $3,024 $1,974 $572 $9,920-$10,000

NPV Acceptance criteria

We usually accept a project if it has a positive NPV and one that is highest amongst the projects we are evaluating. This example project results in a NPV of $425 at the weighted average cost of capital of 12%, thus this is the amount in present value terms that we would gain if we were to invest in it. Yet if this company had a cost of capital of 15%, at this rate the project would yield no gains and we would discard the idea of putting our money in it.

NPV for Projects with irregular cash flows

So far we have discussed formula and calculation of NPV when cash flows are periodic such as daily, weekly, fortnightly, monthly, quarterly, semi-annually, or yearly. When cash flows are not periodic we have to resort to discount each of the cash flows at the time period relative to the first cash flow. We would need to have the dates of each of the net cash flows so to find the time period for each of the net cash flows. If we were to designate the date of the first cash flow as d0, and let us designate di for date of cash flow CFi. The time period t at which to discount a cash flow CFi can found by the formula t=[di-d0]/365 here we use 365 days in a year.

XNPV Calculation for non periodic cash flows

Let me show you how we may find net present value for non periodic cash flows which is sometimes referred to as XNPV function in Excel. As I said earlier, besides having the free cash flows we would also need to have dates for each of the net cash flows. Let us start calculating XNPV with sample cash flows where we have an initial expense of $10,000 at Jan 1, 2010 followed by four cash inflows in amounts of $3000 at the following four dates spanning two years: April 01 2010, July 30 2010, December 15 2010, and January 31, 2011. Let us use a cost of capital of 9%. The following table shows the calculation of XNPV for non periodic cash flows.

XNPV at 9%
Date 01/01/2010 04/01/2010 07/30/2010 12/15/2010 01/31/2011 N Net Cash Flows PVIF @ 9% 1 0.979 0.9516 0.9211 0.911 NPV = Present Value $-10,000 $2,937 $2,854.8 0 $2,763.3 0 $2,733 1,288.10

0 $-10000 0.246461187215 $3000 0.575228310502 $3000 0.953424657534 $3000 1.08219178082 $3000

NPV Replacement Chain Analysis

On this page we explain how to find NPV for projects having unequal lives with the aid of Replacement Chain Analysis. You will learn how a project with longer life span may seem to have a higher NPV as compared to the short lived project yet when one replicates the projects and finds NPV Chain with the replacement chain method the results are quite the opposite.

NPV (net present value)

A present value is the value now of a stream of future cash flows, negative or positive. The value of each cash flow needs to be adjusted for risk and the time value of money. A net present value (NPV) includes all cash flows including initial cash flows such as the cost of purchasing an asset, whereas a present value does not. The simple present value is useful where the negative cash flow is an initial one-off, as when buying a security (see DCF valuation for more detail) A discount rate needs to be used to adjust for risk and time value, and it is applied like this: NPV = CF0 + CF1/(1+r) + CF2/(1+r)2 + CF3/(1+r)3 ... where CF 1 is the cash flow the investor receives in the first year, CF2 the cash flow the investor receives in the second year etc. and r is the discount rate. The series will usually end in a terminal value, which is a rough estimate of the value at that point. It is usual for this to be sufficiently far in the future to have only a minor effect on the NPV, so a rough estimate,usually based on a valuation ratio, is acceptable. Periods other than an year could be used, but the discount rate needs to be adjusted. Assuming we start from an annual discount rate then to adjust to another period we would use, to

get a rate i, given annual rate r, for a period x, where x is a fraction (e.g., six months = 0.5) or a multiple of the number of years: i + 1 = (r + 1)x To use discount rates that vary over time (so r1 is the rate in the first period, r2 = rate in the second period etc.) we would have to resort to a more basic form of the calculation: NPV = CF0 + CF1/(1+r1) + CF2/((1+r1) (1+r2)) + CF3/((1+r1) (1+r2) (1+r3)) ... This would be tedious to calculate by hand but is fairly easy to implement in a spreadsheet.

Weaknesses of NPV
The NPV calculation is very sensitive to the discount rate: a small change in the discount rates causes a large change in the NPV. As the estimate of the appropriate discount rate is uncertain, this makes NPV numbers very uncertain (see CAPM and WACC). An NPV also often relies on uncertain forecasts of future cash flows. How much of a problem this is obviously depends on how uncertain the forecasts are. One solution to both problems is to calculate a range of NPV numbers using different discount rates and forecasts, so that one can generate, for example, best, worst and median case NPV numbers, or even a probability distribution for the NPV (possibly using something like a Monte-Carlo approach).