Net Present Value NPV

1
Net Present Value (NPV)
Payback and ARR methods of investment appraisal
ignore the time value of money but, as we know,
100 now is worth more than 100 in 5 years. The
NPV method takes this into account future sums
are discounted (reduced) to reflect this lower
value. BUT discount rates do vary for example, a
firm with cash-flow problems will have a high
discount rate as it needs money NOW, whereas a
secure firm will a have lower discount
rate. Generally, the current rate of interest
shows what can be earned on money received
immediately, therefore this acts as a guide to
the discount that should be applied to money in
the future. Discount Cash Flow (DCF) This is how
you reduce the value of future sums, therefore as
time goes by the present value of a given sum
declines. The higher the rate, the lower the
value. Example Present value of 1 at discount
rate Yr 5 10 15 0 1.0 1.0 1.0 1 0.952
0.909 0.870 2 0.907 0.826 0.756 3 0.864 0.75
3 0.658 4 0.823 0.683 0.572 5 0.784 0.621 0.
497
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Calculating the NPV Example Project A costs 100
initially. It then provides an annual return of
25 for 5 years. The discount rate is 5. What is
the NPV? Yr Net return x Discount
factor Present Value 0 -100 x 1.0 -100 1
25 x 0.952 23.8 2 25 x 0.907 22.675 3
25 x 0.864 21.6 4 25 x 0.823 20.575
5 25 x 0.784 19.6 Present Value of
total cash inflow 108.25 NPV 8.25 In
accounting terms, the investment produces a
profit of 125-100 25. In NPV it is only 8.25.
BUT this is still a positive outcome. On
financial grounds, any positive NPV is worthwhile
(and vice versa).

• Advantages of NPV
• Considers the time value of money.
• Good for analysis of single projects.
• A positive NPV means accept, a negative means
  reject.

• Disadvantages of NPV
• Based on an arbitrary discount rate.
• Time consuming and harder to calculate.
• Difficult to understand.

3
Investment Appraisal- comparisons of various
methods