18 Net present value
Net present value (NPV) or net present worth (NPW) is defined as the sum of the present values (PVs) of incoming and outgoing cash flows over a period of time. Incoming and outgoing cash flows.
Time value of money dictates that time affects the value of cash flows. In other words, a lender may give you 99 cents for the promise of receiving $1.00 a month from now, but the promise to receive that same dollar 20 years in the future would be worth much less today to that same person (lender), even if the payback in both cases was equally certain. This decrease in the current value of future cash flows is based on the market dictated rate of return. More technically, cash flows of nominal equal value over a time series result in different effective value cash flows that makes future cash flows less valuable over time.
Essentially if NPV < 0, a proposed project will not be initiated because it is projected to lose money over the projected lifetime.
For example, an investment of $500,000 today is expected to return $100,000 of cash each year for 10 years. The $500,000 being spent today is already a present value, so no discounting is necessary for this amount. However, the future cash receipts of $100,000 for 10 years need to be discounted to their present value. Let’s assume that the receipts are discounted by 14% (the company’s required return). This will mean that the present value of the those future receipts will be approximately $522,000. The $522,000 of present value coming in is compared to the $500,000 of present value going out. The result is a net present value of $22,000 coming in.
Procedure
- Select the discount rate.
- Identify the costs/benefits to be considered in analysis.
- Establish the timing of the costs/benefits.
- Calculate net present value of each alternative.
- Select the offer with the best net present value.