Published On:Thursday, 22 December 2011
Posted by Muhammad Atif Saeed
Net Present Value:
“Definition: Difference between the Present cash inflows and cash outflows.”
“Difference between all expected cash flows less initial investment.”
Measurement: Discounted cash flow (DCF) techniques are used in calculating the net present value of a series of cash flows. This measures the change in shareholder wealth now as a result of accepting a project.
NPV = present value of cash inflows less present value of cash outflows
- If the NPV is positive, it means that the cash inflows from a project will yield a return in excess of the cost of capital, and so the project should be undertaken if the cost of capital is the organization’s target rate of return.
- If the NPV is negative, it means that the cash inflows from a project will yield a return below the cost of capital, and so the project should not be undertaken if the cost of capital is the organisation's target rate of return.
- If the NPV is exactly zero, the cash inflows from a project will yield a return which is exactly the same as the cost of capital, and so if the cost of capital is the organisation's target rate of return, the project will have a neutral impact on shareholder wealth and therefore would not be worth undertaking because of the inherent risks in any project.
Net Present Value overview:
- The terminal value of an investment is its value at some point in the future, including an allowance for interest.
- Discounting converts a sum of money receivable or payable in the future to its present value, which is the cash equivalent now of the future value.
- Discounted cash flow (DCF) techniques discount all the forecast cash flows of an investment proposal to determine their present value.
- The net present value (NPV) of a project is the difference between its projected discounted cash inflows and discounted cash outflows.
- The decision rule is to accept a project with a positive NPV.
- An annuity is a constant cash flow for a number of years.
- The net terminal value (NTV) is the cash surplus remaining at the end of a project after taking account of interest and capital payments.
- One of the principal advantages of the DCF appraisal method is that it takes account of the time value of money. The payback method can be combined with DCF to calculate a discounted payback period.
The advantages of NPV are as follows:
- It is directly linked to the assumed objective of maximizing shareholder wealth as it measures, in absolute (£) terms, the effect of taking on the project now, i.e. year 0
- It considers the time value of money, i.e. the further away the cash flow the less it is worth in present terms.
- It considers all relevant cash flows, so that it is unaffected by the accounting policies which cloud profit-based investment appraisal techniques such as ARR
- Risk can be incorporated into decision making by adjusting the company’s discount rate.
- It provides clear, unambiguous decisions, i.e. if the NPV is positive, accept; if it is negative, reject.
