Net Present Value



The sum of the present values of the annual cash flows minus the initial investment.



Steps:
  1. Identify the size and timing of the expected future cash flows generated by the project or investment.
  2. Determine the discount rate or the estimated rate of return for the project. T
  3. Calculate the NPV.




OR


Co

Initial investment made at the beginning of the project. This value is usually negative, since most projects involve an initial cash outflow. The initial investment can include costs such as hardware, software licensing fees, startup costs, etc.

Cash Flows:

The net cash flow for each year of the project: benefits - costs

Rate of Return

The rate of return is the expected reward investors demand for investing in the project considering the level of risk of the company and the project. The rate of return is calculated by looking at comparable investment alternatives given the risk of the project. The rate of return is often referred to as the discount, interest, hurdle rate, or company cost of capital. Companies usually use a standard rate for the project as they approximate the risk of the project to be on average the risk of the company as a whole.

t

Number of years depicting the lifetime of the project


Variations:

Simple Cash Flows: Single cash flow in a specified period in time in the future

Annuities: Constant cash flows occurring at regular time intervals during a fixed period of time

Growing Annuities: Cash flows growing at a constant rate over a period of time.

Perpetuities: Constant cash flow at regular intervals in perpetuity or for ever

NPV:
  • highly useful in making capital budgeting decisions (The rule is to invest in the project if the NPV is greater or equal to zero).
  • recognizes the time value of money concept that says a dollar earned today is worth more than a dollar earned five years from now.
  • calculates the expected cash flows generated from the project and incorporates the unique risks of obtaining those cash flows
  • incorporates the risks associated with the project via the expected cash flows and/or discount rate
  • flexible tool and can be combined with other financial evaluation tools, such as: