Net present value

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In finance, the net present value (NPV) or net present worth (NPW)[1] of a time series of
cash flows, both incoming and outgoing, is defined as the sum of the present values (PVs) of
the individual cash flows. In the case when all future cash flows are incoming (such as
coupons and principal of a bond) and the only outflow of cash is the purchase price, the NPV
is simply the PV of future cash flows minus the purchase price (which is its own PV). NPV is
a central tool in discounted cash flow (DCF) analysis, and is a standard method for using the
time value of money to appraise long-term projects. Used for capital budgeting, and widely
throughout economics, finance, and accounting, it measures the excess or shortfall of cash
flows, in present value terms, once financing charges are met.

The NPV of a sequence of cash flows takes as input the cash flows and a discount rate or
discount curve and outputting a price; the converse process in DCF analysis, taking as input a
sequence of cash flows and a price and inferring as output a discount rate (the discount rate
which would yield the given price as NPV) is called the yield, and is more widely used in
bond trading.

Contents
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 1 Formula
 2 The discount rate
 3 What NPV Means
 4 Example
 5 Common pitfalls
 6 History
 7 Alternative capital budgeting methods
 8 References

[edit] Formula
Each cash inflow/outflow is discounted back to its present value (PV). Then they are
summed. Therefore NPV is the sum of all terms,

where

t - the time of the cash flow

 i - the discount rate (the rate of return that could be earned on an investment in the
financial markets with similar risk.)
Rt - the net cash flow (the amount of cash, inflow minus outflow) at time t. For
educational purposes, R0 is commonly placed to the left of the sum to emphasize its
role as (minus) the investment.

The result of this formula if multiplied with the Annual Net cash in-flows and reduced by
Initial Cash outlay will be the present value but in case where the cash flows are not equal in
amount then the previous formula will be used to determine the present value of each cash
flow separately. Any cash flow within 12 months will not be discounted for NPV purpose.[2]

[edit] The discount rate

Main article: Discount rate

The rate used to discount future cash flows to their present values is a key variable of this
process.

A firm's weighted average cost of capital (after tax) is often used, but many people believe
that it is appropriate to use higher discount rates to adjust for risk or other factors. A variable
discount rate with higher rates applied to cash flows occurring further along the time span
might be used to reflect the yield curve premium for long-term debt.

Another approach to choosing the discount rate factor is to decide the rate which the capital
needed for the project could return if invested in an alternative venture. If, for example, the
capital required for Project A can earn five percent elsewhere, use this discount rate in the
NPV calculation to allow a direct comparison to be made between Project A and the
alternative. Related to this concept is to use the firm's Reinvestment Rate. Reinvestment rate
can be defined as the rate of return for the firm's investments on average. When analyzing
projects in a capital constrained environment, it may be appropriate to use the reinvestment
rate rather than the firm's weighted average cost of capital as the discount factor. It reflects
opportunity cost of investment, rather than the possibly lower cost of capital.

An NPV calculated using variable discount rates (if they are known for the duration of the
investment) better reflects the real situation than one calculated from a constant discount rate
for the entire investment duration. Refer to the tutorial article written by Samuel Baker[3] for
more detailed relationship between the NPV value and the discount rate.

For some professional investors, their investment funds are committed to target a specified
rate of return. In such cases, that rate of return should be selected as the discount rate for the
NPV calculation. In this way, a direct comparison can be made between the profitability of
the project and the desired rate of return.

To some extent, the selection of the discount rate is dependent on the use to which it will be
put. If the intent is simply to determine whether a project will add value to the company,
using the firm's weighted average cost of capital may be appropriate. If trying to decide
between alternative investments in order to maximize the value of the firm, the corporate
reinvestment rate would probably be a better choice.
Using variable rates over time, or discounting "guaranteed" cash flows differently from "at
risk" cash flows may be a superior methodology, but is seldom used in practice. Using the
discount rate to adjust for risk is often difficult to do in practice (especially internationally),
and is difficult to do well. An alternative to using discount factor to adjust for risk is to
explicitly correct the cash flows for the risk elements using rNPV or a similar method, then
discount at the firm's rate.

[edit] What NPV Means

NPV is an indicator of how much value an investment or project adds to the firm. With a
particular project, if Rt is a positive value, the project is in the status of discounted cash
inflow in the time of t. If Rt is a negative value, the project is in the status of discounted cash
outflow in the time of t. Appropriately risked projects with a positive NPV could be accepted.
This does not necessarily mean that they should be undertaken since NPV at the cost of
capital may not account for opportunity cost, i.e. comparison with other available
investments. In financial theory, if there is a choice between two mutually exclusive
alternatives, the one yielding the higher no-no should be selected.

If... It means... Then...

NPV the investment would
the project may be accepted
> 0 add value to the firm
the investment would
NPV
subtract value from the project should be rejected
<0
the firm
We should be indifferent in the decision whether to accept or
the investment would
NPV reject the project. This project adds no monetary value. Decision
neither gain nor lose
=0 should be based on other criteria, e.g. strategic positioning or
value for the firm
other factors not explicitly included in the calculation.

[edit] Example
A corporation must decide whether to introduce a new product line. The new product will
have startup costs, operational costs, and incoming cash flows over six years. This project
will have an immediate (t=0) cash outflow of $100,000 (which might include machinery, and
employee training costs). Other cash outflows for years 1–6 are expected to be $5,000 per
year. Cash inflows are expected to be $30,000 each for years 1–6. All cash flows are after-
tax, and there are no cash flows expected after year 6. The required rate of return is 10%. The
present value (PV) can be calculated for each year:

Year Cash flow Present value

T=0 -$100,000

T=1 $22,727

T=2 $20,661
 T=3 $18,783

T=4 $17,075

T=5 $15,523

T=6 $14,112

The sum of all these present values is the net present value, which equals $8,881.52. Since
the NPV is greater than zero, it would be better to invest in the project than to do nothing, and
the corporation should invest in this project if there is no mutually exclusive alternative with
a higher NPV.

The same example in Excel formulae:

 NPV(rate,net_inflow)+initial_investment
 PV(rate,year_number,yearly_net_inflow)

More realistic problems would need to consider other factors, generally including the
calculation of taxes, uneven cash flows, and salvage values as well as the availability of
alternate investment opportunities.

[edit] Common pitfalls

  If, for example, the Rt are generally negative late in the project (e.g., an industrial or
mining project might have clean-up and restoration costs), then at that stage the
company owes money, so a high discount rate is not cautious but too optimistic. Some
people see this as a problem with NPV. A way to avoid this problem is to include
explicit provision for financing any losses after the initial investment, that is,
explicitly calculate the cost of financing such losses.

 Another common pitfall is to adjust for risk by adding a premium to the discount rate.
Whilst a bank might charge a higher rate of interest for a risky project, that does not
mean that this is a valid approach to adjusting a net present value for risk, although it
can be a reasonable approximation in some specific cases. One reason such an
approach may not work well can be seen from the following: if some risk is incurred
resulting in some losses, then a discount rate in the NPV will reduce the impact of
such losses below their true financial cost. A rigorous approach to risk requires
identifying and valuing risks explicitly, e.g. by actuarial or Monte Carlo techniques,
and explicitly calculating the cost of financing any losses incurred.

 Yet another issue can result from the compounding of the risk premium. R is a
composite of the risk free rate and the risk premium. As a result, future cash flows are
discounted by both the risk-free rate as well as the risk premium and this effect is
compounded by each subsequent cash flow. This compounding results in a much
lower NPV than might be otherwise calculated. The certainty equivalent model can be
used to account for the risk premium without compounding its effect on present value.
[citation needed]

 If NPV is negative the project should not be immediately rejected. Sometimes

companies have to execute an NPV-negative project if not executing it creates even
more value destruction.

 Another issue with relying on NPV is that it does not provide an overall picture of the
gain or loss of executing a certain project. To see a percentage gain relative to the
investments for the project, usually, Internal rate of return or other efficiency
measures are used as a complement to NPV.

[edit] History
Net present value as a valuation methodology dates at least to the 19th century. Karl Marx
refers to NPV as fictitious capital, and the calculation as capitalising, writing:[4]

The forming of a fictitious capital is called capitalising. Every periodically repeated income is
capitalised by calculating it on the average rate of interest, as an income which would be
realised by a capital at this rate of interest.

In mainstream neo-classical economics, NPV was formalized and popularized by Irving

Fisher, in his 1907 The Rate of Interest and became included in textbooks from the 1950s
onwards, starting in finance texts.[5][6]

[edit] Alternative capital budgeting methods

 Adjusted present value (APV): adjusted present value, is the net present value of a
project if financed solely by ownership equity plus the present value of all the benefits
of financing.
 Payback period: which measures the time required for the cash inflows to equal the
original outlay. It measures risk, not return.
 Cost-benefit analysis: which includes issues other than cash, such as time savings.
 Real option method: which attempts to value managerial flexibility that is assumed
away in NPV.
 Internal rate of return: which calculates the rate of return of a project while
disregarding the absolute amount of money to be gained.
 Modified internal rate of return (MIRR): similar to IRR, but it makes explicit
assumptions about the reinvestment of the cash flows. Sometimes it is called Growth
Rate of Return.
 Accounting rate of return (ARR): a ratio similar to IRR and MIRR