The NPV, which stands for Net Present Value is a financial analysis technique which is majorly used for analysing the viability of an investment in a project or a firm. The difference between the present value of future cash flows and the initial investment is the NPV of future cash flows.This article has been written with an intention to provide you with a detailed view and computation of NPV.
Meaning of Net Present Value
As a company grows, it must make key decisions that require significant capital expenditure. An organisation must make well-informed judgments about business expansion & investment. In such circumstances, the firm will use Capital Budgeting tools, which are one of the most often used NPV methods, to determine the most profitable investment.
Net present value is a capital budgeting measure used to assess a project’s or an investment’s profitability. The difference between the present value of cash inflows and present value of cash withdrawals which is outflowing from the entity over a period of time is used to compute it.
Net present value is the net off of the present value of cash inflows and outflows by discounting the cash inflows at a predetermined rate, as is implied by the name.
The formula for computing NPV would be as given below:
NPV = Rt/(1+i) t
Here,
t = Time of the cash flow
i = Rate of Discount
Rt = Net Cashflow
As it is implied in the above given formula, we must discount the cash flows at a specific rate in order to compute their present value. This rate is calculated by comparing the return on an investment with a similar risk or borrowing cost that might be incurred by the entity.
The time value of money is used into the computation of NPV. Simply expressed, the time value of money states that a rupee is worth more now than tomorrow. The present value of the cash flows is used to analyse if a project is worthwhile.The initial investment is deducted after discounting the cash flows across various time periods to which they belong.
The entity would take up or accept the project if the result has a positive NPV. And it shall be rejected if the project is showing off a result of negative NPV.
If the NPV is zero, the company will remain neutral or indifferent.
Illustration for NPV
Say X Ltd. is looking to take up a new project, and for this, it will have to make an initial investment of INR 10,00,000. The investment is expected to bring an inflow of cash in a span of 5 years. The cash inflow during the first year will be INR 1,50,000, the second year will be INR 2,00,000, the third year will be INR 2,85,000, the fourth year will be INR 3,50,000, and lastly, in the fifth year, it shall earn cash inflow of INR 4,65,000. Here, assume that the discount rate is 10%. Using this, the NPV computation would be made as below:
| Year | Cash Inflow | Computation at 10% | Present Value |
| 0 | (10,00,000) | – | (10,00,000) |
| 1 | 1,50,000 | 1,50,000/ (1.10)1 | 1,36,363.64 |
| 2 | 2,00,000 | 2,00,000/ (1.10)2 | 1,65,289.26 |
| 3 | 2,85,000 | 2,85,000/ (1.10)3 | 2,14,124.72 |
| 4 | 3,50,000 | 3,50,000/ (1.10)4 | 2,39,054.71 |
| 5 | 4,65,000 | 4,65,000/ (1.10)5 | 2,88,728.42 |
Now, with the initial investment of INR 10,00,000 made by the company in the project and the cash inflows earned each year, the total would be INR 14,50,000. However, each of them has been discounted, using a rate of return of 10%. Thus, it gives an earning of INR 1,36,363.64 during the first year, INR 1,65,289.26 for the second year, INR 2,14,124.72 for the third year, INR 2,39,054.71 during the fourth year and INR 2,88,728.42 during the final year totalling to INR 10,43,561.
Here, the NPV will be equal to the difference between the present value of cash inflows and the cash outflows, which will be INR 43,561 [INR 10,43,561 – INR 10,00,000]. As this is a positive NPV, the company should take up the project.
Benefits Of Using NPV
Following are some of the benefits which are provided by NPV:
1. A comprehensive tool
All inflows, outflows, associated risks and time duration are factored into the net present value calculation. As a result, NPV is a complete tool that takes into account all factors involved in an investment.
2. Time Value of Money
The NPV, or the net present value approach, is a tool that is used to determine a project’s profitability that can be earned by the entity with the investment it is making in the same. It takes the major concept, which is the time value of money, into account. This is majorly considered for addressing the fact that the value of future cash flows will be lower than the value of today’s cash flows. As a gain from the same, the greater the cash flow is, the lower the value will be. This is a critical factor that should be taken into account when using the NPV approach.
This allows the organisation to compare two similar projects in a sensible and prudent manner. For example, if Project A, with a life of 4 years, has higher cash flows in the initial period and Project B, with a life of 4 years, has higher cash flows in the latter period, the organisation can use NPV to wisely choose Project A because inflows today are more valuable than inflows later on.
3. Value of Investment to be made
The Net Present Value approach not only determines whether or not a project will be lucrative but also determines the entire profit value. After discounting the cash flows, the project will gain INR 43,561, as depicted in the example discussed above. The tool calculates the profit or loss on an investment that the company is making in a project or opportunity it has kept before it.
Disadvantages of Using NPV
Along with the above-discussed advantages, there are also certain disadvantages that apply to the NPV approach, and these have been discussed below:
1. Discounting Rate
The most significant disadvantage posed by NPV or Net Present Value is the need to compute the rate of return that might be possibly earned.If a larger rate of return is anticipated, the NPV will be falsely negative, and if a lower rate of return is considered or expected, the project will be falsely profitable, resulting in incorrect decision making.
2. Projects may not be Comparable
The NPV cannot be adopted for the conducting of comparison of two projects which are not belonging to the same period of time. Due to the fact that many firms have a set budget and occasionally have two project options, NPV cannot be used to compare two projects that are different in terms of time or risk.
3. Chances of forming Multiple Assumptions
In terms of inflows and outflows, the NPV technique incorporates a number of assumptions. It’s possible that a significant amount of money will be spent only once the project is up and running. In addition, inflows may not always be as anticipated. Most software today performs the NPV analysis and assists managers in making decisions. Despite its flaws, the NPV technique is quite effective in capital budgeting and is extensively employed.
Thus, it can be concluded that NPV is one of the best tools available currently for analysing and deciding upon a possible project which company should take up or make investment of their fund. But with all the advantages enjoyed by this approach there are also certain disadvantages posed by the tool, which should be taken care of by adopting the measures that would mitigate or reduce the disadvantages applicable.
It should also be kept in mind that NPV or any other tools can only provide you with possible insights and forecasts. It can never
