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Net Present Value - NPV

An approach used in capital budgeting where the present value of


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.

a. If the discount rate for this project is 10 percent, what is the


project NPV?

b. What is the project IRR?


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.

Net Present Value Example

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 expected cash flows are calculated by multiplying each probability by


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

Net present value


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.)

I work in the finance field (Chartered Accountant).


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.

Unfortunately, sometimes there's no way to simplify an idea without losing


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.)

From the original questioner:


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.