Transcript Net Present Value (NPV)

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
0.753
0.658
4
0.823
0.683
0.572
5
0.784
0.621
0.497
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
=
+108.25
=
+8.25
Present Value of total cash inflow
NPV
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:
Disadvantages of NPV:
•Considers the time value of money.
•Based on an arbitrary % discount rate.
•Good for analysis of single projects.
•Time consuming and harder to
A positive NPV means accept, a
calculate.
negative means reject.
•Difficult to understand.
Investment Appraisal- comparisons of various
methods
Method
Advantages
Disadvantages
Easy to calculate
Does not take into account timing of
cash flow
Easy to understand
Does not take into account future
value of money.
Average Rate of Return
All cash flows are taken into account.
Easy to calculate
Cash flow after the payback period is
ignored.
Easy to understand
Ignores timing of cash flow within
payback period.
Places emphasis on earlier cash flow
which is most likely to be accurate.
Does not take account of future value
of money.
Payback
Most useful for high technology
projects.
All cash flows are used
Not so easy to understand. The
meaning is not always clear.
The timing of cash flows is taken into
account.
Difficult to calculate.
Takes account of the future value of
cash flow.
Difficult to determine the cost of
capital.
Discounted Cash Flow
Only financial measures.
Cost Benefit Analysis
Takes factors other than financial ones
into account.
Difficult to calculate.
Useful for evaluating projects that have
a social impact.
Social costs are difficult to quantify.