There are many methodologies to evaluate a project or business proposal. If you are investing some money on a project, then you must get some return from the project in future. The return may be lump sum or in the form of several cash flows, during a period of time. It is crucial to analyze the project in question, on the basis of return obtained from the project to ascertain whether the project is profitable or not. Net Present Value (NPV) is such a method to evaluate projects which helps us to take the best investment decision and to select the best alternative among various options available.
What is Net Present Value (NPV)?
Let us take a business ‘XYZ’, and suppose you have invested some amount in that business. You will get returns from your investments in the form of cash flows time to time. How will you compare whether you are in profit or loss? One can say that just tally total cash inflows and total cash outflows and compare them. But the problem is that the timings of occurrence of cash inflows and cash outflows is different. Mostly, the cash inflow incurs during the initial phase of the project and the cash outflows are obtained in subsequent phases of the project. So comparing them straightforward, without taking into account the time factor will not give you true value. Here the ‘Net Present Value (NPV)’ comes into picture.
Net Present Value is the difference between present value of all cash inflows and present value of all cash outflows during a certain period of time. The present value of all the future payments is calculated using the discount rate and compared with the present value of all the cash inflows. The difference between the two gives NPV of a project or investment.
Net Present Value (NPV) is useful in investment planning and capital budgeting of a project. A project or investment proposal may be analyzed for its profitability, using this concept.
How the Net Present Value (NPV) is Calculated?
Net Present Value (NPV) may be calculated by the following methods:
(a) Using the formula: NPV may be calculated using the following formula.
Net Present Value (NPV) =
Cash flow1, cash flow 2 ,…………..cash flow n are the cash flows in period (say year) 1, 2,………….n.
r= Discount rate
n= number of periods
(b) Using the Excel
NPV can easily be calculated using excel. For calculating the NPV using the excel, follow the below mentioned steps (also see screenshots):
In excel, the NPV formula appears like:
=NPV(discount rate, series of cash flow)
Step 1: Open spreadsheet and type the discount rate in a cell.
Step 2: Type the series of cash flows in consecutive cells.
Step 3: Type “=NPV(“ and select the discount rate “,” then select the cash flow cells and “)”.
Step 4: Hit the ‘enter’ key and NPV will be calculated and appeared in the cell as shown in the screenshot below.
Example 1: Calculate the NPV of the project having the following data:
Discount rate= 8.7%
Cash flows are given in following table:
Steps 1,2, and 3
You can see that the NPV value of the project is $890.28.
Now what happens when one of the cash flows of the project is negative?
Let us see it in the example 2 below.
Example 2: Calculate the NPV of the project having the following data:
Discount rate= 8.7%
Cash flows are given in following table:
Here the cash flow in the year 1 is shown as negative because it represents the initial investment by the investor and hence it is showing cash outflow.
Step 1: Write the values of discount rate and cash flows in the spreadsheet and write the formula for NPV.
Step 2: Hit the enter key and get the value of NPV.
Significance of Net Present Value (NPV)
Net Present Value (NPV) gives the present value of all your cash flows (positive or negative) and help analyzing whether a project is profitable or not. The calculation of Net Present Value (NPV) may have three possible outcomes:
NPV is Positive: It means that the present value of all future cash flows is positive and the project is profitable and worth investing.
NPV is Negative: A negative NPV means that the present value of all the future cash flows is negative and we will lose money if we will go ahead with the project.
NPV is Zero: The zero NPV means that the project is neither profitable nor at loss. A project with zero NPV may still be considered if there are significant intangible benefits from the project such as, enhancement in brand value of the company, strategic position, customer satisfaction, etc.
Limitations of NPV
One of the limitations of NPV is that it takes into account the estimation of future cash flows, which may not prove to be correct. The discount rate taken is also an estimation and there are chances of errors in the estimation. Moreover, NPV formula doesn’t evaluate a project’s return on investment (ROI), a key consideration for someone having finite capital. This method does not take into account the size of the project. Looking only on the NPV will not give you the idea of the size of the project and size of the project (total capital required, etc.) is the key matrix for the decision making.
You can understand this with the following example.
Suppose there are two projects, ‘A’ and ‘B’.
Project ‘A’ has an NPV of USD 500 and Project ‘B’ has an NPV of USD 50. Which one you feel the best option? By looking only at the NPV value, one may say that option ‘A’ with NPV of USD 500 is better. But is it true always? Does deciding solely based on NPV can give you clear picture.
Let us add more information to it. The Project ‘A’ requires an initial investment of USD 5000 and the project ‘B’ requires the initial investment of USD 5. Now which one is better? Obviously the Project ‘B’ which is giving you more returns on your investment.
You can easily conclude from above that decision which are based only on the NPV value are not always the best decisions as this method does not capture return on investment (ROI), which is a key deciding factor.
Pros and Cons of NPV
Net Present Value (NPV) is a very useful method to know whether a project will be profitable or not, and hence, this tool can help in investment planning or capital budgeting of a project. It takes into account the discount rate and future cash flow to give you the present value of future cash flows. However, there are certain limitations of this tools also, such as it depends mainly on inputs, long term projections of cash flows, which may not be correct always. It does not take into account size of the project or return on investment (ROI), which is a key decision matrix. Other limitation is that It depends on the quantitative inputs and does not consider nonfinancial factors. Therefore, looking into NPV value may not always give you the clear picture of the project. Other methods like payback method or ‘internal rate of return (IRR)’ method should also be employed to make the investment decisions along with this method.