Money you have in your pocket now is more valuable than money you will have in the future. Why? Because, you can take that money, and use it now to run your business, or buy something now and sell it later. You can also put it in the bank and earn interest. But, to make smart investment decisions, you need to know when the best time to invest is. So, how do we compare the value of money now, with the value of money in the future?
Enter the term Net Present Value (NPV)
NPV calculates and compares if projects are worth the investment. It is a time value of money calculation. This is a commonly used term in the mind of experienced CFOs and business people, as it one of the most popular evaluation methods of capital budgeting. The net present value (NPV) is often a good way to analyze the profitability of an investment. However, like many methods in finance, it isn’t the end-all, be-all solution. There are negative aspects to NPV. Let’s take a closer look what they are, with attention to the benefits of it, as well.
As we’ve already mentioned, the basic precept of the NPV method is that a dollar in the future is not worth as much as one dollar today. Net present value calculates capital budgeting to have a clearer picture into which projects turn the greatest profit.
Let’s say you have an opportunity to invest $35,000 to expand your operation. You believe that this investment will generate revenues of $10,000, $27,000 and $19,000 for the first, second, and third years, respectively. The required rate of return end of the project and is 12%.
By discounting every future cash flow back at a rate of 10%, and subtracting the initial cash outlay of $35,000, we arrive at a net present value of $10,678 for this project. Under the NPV method, the wise thing would be to commit to this investment, as the NPV is positive.
Real world example
Let’s say you own an electronics company and want to expand your business and purchase another store. NPV will first estimate the future cash flows that the store would generate, then it would discount those cash flows into one lump-sum present value amount, say $600,000. If you are willing to sell your business for less than $600,000, the purchasing company would likely accept the offer as it presents a positive NPV investment. Alternatively, if the store would not sell for less than $600,000, you would not buy the store, as the investment would present a negative NPV.
Advantages of the NPV method
As the NPV method states that a future dollar is worth less than a dollar today, the cash flow, therefore, in every period, is discounted by another period of capital cost.
The NPV method also tells us if an investment will create value for the business, and by how much in terms of dollar value. In the example above, we’ve calculated that the $35,000 investment would increase the company’s value by $10,678 when all cash flows were discounted back to today.
Another advantage of the NPV method takes it considers the cost of capital and the risks that exist in making predictions about the future. Ultimately, a projection of cash flows 5 years into the future is inherently of less certainty than cash flows projected in a closer time period. Cash flows that are projected further in the future have a lesser impact on the net present value than more predictable cash flows that happen in earlier periods.
Disadvantages of NPV
The disadvantage to the net present value method is that it is primarily based on guesswork. If we assume a cost of capital is too low, an investment is suboptimal. And, if we assume the cost of capital is too high, we will forgo a good investment.
As an example, a $1 million project will likely have a much higher NPV than a $1,000 project, even if the $1,000 project provides much higher returns in percentage. If capital is scarce — and it often is — the NPV method isn’t beneficial as it projects that different sizes are not immediately comparable based on the output.
Another disadvantage to the calculation of NPV is how it deals with discount rates. The discount rate used in the denominators of each present value (PV) calculation determines what the final NPV number will be. A small increase or decrease in the discount rate will have an effect on the final output.
Calculating NPV with the right technology
There needs to be accuracy when comparing cash flows for investments. NPV calculations based on inaccurate cash flow data could misrepresent costs and result in sub-optimum selection of equipment and other assets. That’s why In today’s financial landscape, no one calculates NPV by hand. And, project investment technology will allow you to work with an automated calculator that includes an NPV function, and measures whether or not to pursue an investment.