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Net Present Value tutorial

Net Present Value tutorial

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cash inflows is subtracted by the present value of cash outflows. NPV

is used to analyze the profitability of an investment or project.

NPV analysis is sensitive to the reliability of future cash inflows that

an investment or project will yield.

Formula:

NPV compares the value of a dollar today versus the value of that

same dollar in the future, after taking inflation and return into

account.

If the NPV of a prospective project is positive, then it should be

accepted. However, if it is negative, then the project probably should

be rejected because cash flows are negative.

The calculation of net present value is useful when preparing a capital budgeting

project. With this calculator, you can determine whether the the total present value

of a project's expected future cash flows is enough to satisfy the initial cost.

In the calculator fields below enter your required discount rate, also known as the

cost of capital or required rate of return. This is the return you require for the project

to be an attractive investment. Secondly, enter the length of the project (in years)

and the amount required to initiate the project. Finally, enter any projected net cash

flows to be received throughout the life of the project. (If you project any cash

outflows to be greater than inflows, enter a negative number for that net cash flow.)

If you are using the calculator to compare projects, enter in each project's cash flows

separately.

Example:

Growth Enterprises believes its latest project, which will cost $80,000

to install, will generate a perpetual growing stream of cash flows. Cash

flow at the end of this year will be $5,000, and cash flows in future

years are expected to grow indefinitely at an annual rate of 5 percent.

project NPV?

Net present value can be described by the following equation:

NPV = (PV of Cash Inflows) - (PV of Cash Outflows)

Our cash inflow here is a perpetuity that is growing at a constant

annual rate. We calculate perpetuity as described:

PV of growing perpertuity = C / (i - g)

Where:

C = income at the end of the first period

i = the current discount rate

g = the growth rate per period

PV of growing perpertuity = 5000 / (.1 - 0.05)

= 5000/0.05

= $100000

Now we can calculate NPV, since we know there is only one outflow which

occurs immediately:

NPV = (PV of Cash Inflows) - (PV of Cash Outflows)

= $100,000 - $80,000

= $20,000

So the NPV of this project is $20,000

To calculate the IRR, we need to find the discount rate which would

yield an NPV of 0. We can get the proper calculation using the above

NPV calculations:

5000 / (i - 0.05) = 80,000

Now we just need to solve for i:

80000/5000 = i - 0.05

0.0625 = i - 0.05

i = 0.1125

So the IRR for this project would be 11.25%. This is the point at which

the project would break even. Any rate above this would cause a negative

NPV, and any rate below it would cause a positive NPV (as we saw with

the original NPV calculation).

Formula :

Perpetuities

A perpetuity is a series of equal payments over an infinite time period into the future.

Consider the case of a cash payment C made at the end of each year at interest rate i, as

shown in the following time line:

Solving for PV, the present value of a perpetuity is given by:

PV= C / i

Growing Perpetuities

Sometimes the payments in a perpetuity are not constant but rather, increase at a certain

growth rate g .

PV = C / (i-g)

For this expression to be valid, the growth rate must be less than the interest rate, that is,

g<i.

The Net Present Value (NPV) example provides an overview of the NPV

calculation in one of the fastest growing areas in Information Technology:

Security Management. According to Forrester Research, about $43 billion

or 18% of the U.S. software spending will go to system and security

management software and services. Some key statistics on security:

Average security attack damages averaged $290K in the U.S.

30.7% of companies had virus infections in the U.S.; 90% ran antivirus

software

90% of Web apps are vulnerable

92% of end-user software companies are vulnerable to security attacks

FTC (U.S.Federal Trade Commission) received 247,000 complaints of

identify theft in 2004

Net Present Value Example

A medium size company is considering the implementation of a security

management software package. As part of their capital budgeting process,

the company is evaluating the financial benefits of the project. To this end,

the company calculates the Net Present Value of the project by following

the steps below:

Step 1

Establish the expected cash flows or cash generated from the

implementation of the security management software. The expected cash

flows for the project are derived by looking at all the possible cash flows

and their associated probabilities under multiple scenarios. A high cash

flow scenario will include the most optimistic view of the benefits of

installing the security software. Similarly, the low cash flow scenario will

include the most pessimistic view of the benefits of installing the security

software.

Table 1. Cash Flows for Security Management Project (Cost Avoidance Benefits)

Cash Flows

(millions)

Probability

High

10%

Medium

70%

Low

20%

Expected Cash Flow

Year 1

Year2

Year 3

Year 4

Year 5

$2.00

$2.60

$2.00

$2.60

$3.00

$1.20

$1.56

$1.20

$1.56

$1.80

$0.40

$0.52

$0.40

$0.52

$0.60

$1.12

$1.46

$1.12

$1.46

$1.68

the respective cash flows:

Expected cash flow Year 1: Probability High x Cash Flow High Year 1 +

Probability Medium x Cash Flow Medium Year 1 + Probability High x Cash

Flow High Year 1 = .1 x $2.0 + .7 x $1.2 + 0.2 x $.4 = $1.12 M

The calculation above is repeated for years 2-5 above.

Step 2

Establish the discount rate for the project. The discount rate will be

equivalent to the companys cost of capital as the risk of the project is

Q.

It's been a while since I bought anything except by seat-of-the-pants intuition.

Can someone bring me up to speed on Net Present Value calculations for

machinery?

Forum Responses

It would seem to me that what you paid for it, less what you have depreciated it

on your taxes, would equal what its net present value is. That's presuming you

don't still owe on it. Am I close?

From contributor Q:

Here is what I know about NPV. It is the value today of a future payment.

(Present value of revenues - Present value of costs). The equation for present

value is Revenue or Cost/(1+interest rate) to the power of years. Most industry

uses 7-8% interest or hurdle rate, I am pretty sure. You will have to figure out

annual costs and incomes from the machine. Sometimes this can get pretty

detailed. The purchase of the machine is in year 0 so there is no calculation for

that.

Contributor Q, with the highest respect, you lost me totally. Why would a

woodworker need to make such a wild calculation?

From the original questioner:

If you can show a positive NPV to your banker, she might just give you the loan

for that overpriced profile grinder.

If I remember correctly, the calculation requires that you set a reasonable desired

return on investment, market value of the equipment after x years, increase in

productivity, increase or decrease in labour inputs, and so on. The idea of using

the NPV evaluation is that it takes into consideration that money now is worth

more than money later. (More sophisticated tool than other evaluation models.)

NPV is the value of a project, expressed in today's dollars. Value is defined as

increased earnings (or decreased cost) net of expenses incurred to implement

the project - including the interest to finance the project's acquisition and the tax

break that writing off the project affords.

important information.

Seems to me the present value of a machine is what you can sell it for. Too

simple?

From contributor G:

If you bought a machine today and tomorrow it did its job and the money you got

for the job it did was greater than the cost of the machine, you would make the

investment. That is, there would be a profit. The *net* profit would be the gross

receipt minus the machine expense. But you probably also had labor costs,

maybe some energy, etc., so often these operating costs are subtracted from the

profit. You may also want to subtract taxes. You may wish to sell the machine

immediately and add this back into the value. When you are done, you have the

*net present value after taxes*. If the number is positive, then it is a good

investment - it is profitable; if the NPV is negative, then it is not a good

investment.

Now here is the hard part. When you buy a machine, it does not pay back

everything tomorrow, but it will pay you (or generate profit) over a long period of

time - say three years. So, if it will generate $3000 for me in three years, what is

such money worth today? Well, it depends on the interest rate. (One suggested

change from the previous postings: Use an interest rate for a small business that

is the rate at which you can borrow money. Maybe 12% interest rate today.

Sometimes this is called the discount rate.) So, $3000 three years from now

needs to be reduced (discounted) by 12% for every year to get a true value of

that money in today's dollars. So, for year three, we calculate that the value is

$360 less, or $2640. For year two, we again reduce the new value of $2640 by

12%, or $317. So, for year two it is worth $2327. And finally for year one, we

reduce the value by 12% again, giving us $2048.

Stated another way, if you had $2048 that you put in a CD bearing 12% annually

in interest and left the interest to accumulate and earn additional interest, you

would have $3000 in three years. So, the *present value* in my example is

$2048. Now, if I had to invest $2000 in order to get a machine that would pay me

the $3000 in three years, then I subtract the machine cost from the present value

($2048 - $2000), giving me the *net present value* of $48. Another way to look at

this is that the investment of $2000 in a machine that will give me $3000 in three

years will be returning a little more than 12% on my investment - $48 more.

Some people like to figure out what interest rate (discount rate) will give a 0 NPV.

In my example, this is about 12.6%. (If you got a loan for the $2000 and the

interest was over 12.6%, you would lose money!) The value of 12.6% is called

the Internal Rate of Return (IRR). (As mentioned, you may wish to make several

subtractions and additions to your numbers.)

Thank you so much! Your description brought me back to the example used

when I first heard of NPV. In that case, the contemplated acquisition was a chop

optimizer vs. 4 or 5 guys chained to upcut saws.

I get the impression that NPV analysis is more relevant as you move towards

commodity production and less relevant as you move toward specialized

products where strategic purchases and company image are more important to

price premiums. Or is it just that these things are harder to quantify for the

arithmetic?

A former employer of mine (video equipment rentals) recently had to decide if he

was going to buy 25 digital VTRs worth over $1,000,000 when he was assured of

only one rental on them (World's Track & Field). He did, and had trouble sleeping

until they were booked for the SLC games. If he didn't buy them, though, a

competitor may have done so and he could have lost a regular customer.

I can also imagine that changing technology like CNC could not only change the

throughput, but also demand for product and market price if others invested in it

too. Some tools are so versatile that you know darn well that in a year's time

you'll be making something you could never have forecast.

Still, I think I'm going to make use of NPV for my next programme. I think using it

will force me to evaluate all the ins and outs of doing something.

From contributor C:

Net present value, return on capital and rate of return are all methods used to

justify projects or purchases. They are mostly used by large corporations to put a

ranking on all capital projects so they can get the most from their available capital

or to determine if some borrowing is necessary. The ranking is of course

especially necessary when the decision-makers are far removed from the

projects and don't know (or want to know) the details of every project.

For everyone else, it's usually obvious if there is enough potential profit to justify

the purchase. The real danger is in underestimating the total cost of everything

needed to get the job done and then your calculations are for naught. One of the

deliberate abuses of the method (in the large companies) is to not include

everything that will eventually be necessary and then after you start, you create

justification for the rest of the project.

From contributor G:

Contributor C, the problem I see most often is that the NPV or IRR is very good,

but the cash flow is terrible. Small firms use their capital to purchase equipment

rather than borrow and use the cash for slow weeks/months.

From contributor C:

Contributor G, I wish I could say that I have never done that, but it would not be

the truth.

The large corporations usually have a very formal system for capital expenditures

and they have a set amount of retained earnings that is set aside for that

purpose. All the projects compete for those funds through the rate of return

method and yes, the returns are very high - typically 20% minimum and a good

benchmark would be $1 back every year for every $2 you spend. If there is not

enough money to fund the best projects, they are either not approved, delayed,

or they release more stock, sell bonds, or borrow money for the best projects.

These companies even have people to watch the cash balance on an hourly

basis and borrow or loan money for days at a time to maximize return on cash

balances.

The big hazard in this system, other than spending the money for daily

operations, is underfunding projects. This is usually caused by:

1. Trying to beat the rate of return system for a favorite project. After you start the

project, you create justification for the additional capital needed.

2. Underestimating all the equipment, tooling, space, etc. needed to fully

complete the project. It's never ignorance, just being overly optimistic.

3. Unforseen problems. There is usually contingency money for the small

problems, but it never is enough for big problems. There is sometimes a "risk

factor" added to the rate of return system to account for this and new technology

projects naturally carry the highest risk.

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