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What is Net Present Value?

An organization has to take many decisions regarding the expansion of business and investment. In such cases, the organization will take the help of NPV method and base its decision on the same.

Net present value is used in Capital budgeting to analyze the profitability of a project or investment. It is calculated by taking the difference between the present value of cash inflows and present value of cash outflows over a period of time.

As the name suggests, net present value is nothing but net off of the present value of cash inflows and outflows by discounting the flows at a specified rate.

Formula for NPV

NPV = (Cash flows)/( 1+r)i

i- Initial Investment

Cash flows= Cash flows in the time period

r  = Discount rate

i = time period

As seen in the formula – To derive the present value of the cash flows we need to discount them at a particular rate.  This rate is derived considering the return of investment with similar risk or cost of borrowing, for the investment.

NPV takes into consideration the time value of money. The time value of money simply means that a rupee today is of more value today than it will be tomorrow.  

Consider it this way: You have Rs. 100  today and you can buy ten chocolates. The same Rs. 100 will be able to get you not more than the  same 5 chocolates may be after one year. So the cash flows earned today are of more value than as on a later date.  

After discounting the cash flows over different periods, the initial investment is deducted from it.  If the result is a positive NPV then the project is accepted. If the NPV is negative the project is rejected.  And if NPV is zero then the organization will stay indifferent.

Illustration

Let us say Nice Ltd wants to expand its business and so it is willing to invest Rs 10,00,000.

The investment is said to bring an inflow of Rs.  100,000 in first year, 250,000 in the second year, 350,000 in third year, 265,000 in fourth year and 415,000 in fifth year.Assuming the discount rate to be 9%. Let us calculate NPV using the formula.

 

Year Flow Present value Computation
0 -1000000 -1000000
1 100000 91743 100000/(1.09)
2 250000 210419 250000/(1.09)^2
3 350000 270264 350000/(1.09)^3
4 265000 187732 265000/(1.09)^4
5 415000 269721 415000/(1.09)^5

 

             Here NPV is Rs.  29881.

Since the NPV is positive the investment is profitable and hence Nice Ltd can go ahead with the expansion.

Advantages of Net present value method

Time value of money

Net present value method is a tool for analyzing profitability of a particular project. It takes into consideration time value of money. The cash flows in the future will be of lesser value than the cash flows of today.  And hence the further the cash flows, lesser will the value. This is a very important aspect and is rightly considered under the NPV method.

Comprehensive tool

Net present value takes into consideration all the inflows, outflows and risk involved.  Therefore NPV is a comprehensive tool taking into consideration all aspects of the investment.  

Value of investment

The Net present value method not only states if a project will be profitable or not,  but also gives the value of total profits. Like in the above example the project will gain Rs. 29881 after discounting the cash flows.

Limitations of the Net Present Value method

Discounting rate

The main limitation of Net present value is that the rate of return has to be determined.  If a higher rate of return is assumed, it can show false negative NPV, also if a lower rate of return is taken it will show the false profitability of the project and hence result in wrong decision making.

Different projects are not comparable

NPV cannot be used to compare two projects. Considering the fact that many businesses have a fixed budget and sometimes have two project options,  NPV cannot be used for comparing the two projects because of the size of the projects.

Multiple Assumptions

The NPV method also makes a lot of assumptions in terms of inflows,  outflows. There might be a lot of expenditure that will come to surface only when the project actually takes off.  Also the inflows may not always be as expected.

Today most softwares perform the NPV analysis and assist management in decision making.  With all its limitations, the NPV method in capital budgeting is very useful and hence is widely used.  

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