Net present value (NPV)

Last updated: 17.03.2016

Net present value (NPV) is a method for investment appraisal that is based on discounted cash-flow methodology. It shows the amount by which shareholder´s wealth would be increased. It is calculated as the total of present values of future relevant cash-flows over the project life. It comes out from relevant future cash-flows (free cash-flow) shown for each year under consideration, discounts separately each year´s net cash-flow and calculates the total net present value (NPV) over the life of the investment project. NPV of viable project shall be positive.

  • if NPV > 0 → the investment adds value to the company → can be accepted (not necessarily must be, because there can be alternative projects yielding higher NPV (30) or budget can be insufficient)
  • if NPV < 0 → the investment does not add value to the company → shall be refused

 

Advantages of NPV compared to investment appraisal methods not prepared on the basis of discounted cash-flow

  • it considers all relevant cash inflows and outflows over the entire life of the project
  • it is based on cash-flow, not profit which is easy to manipulate
  • considers timing of cash-flows and discounts them, therefore respects time value of money concept (gives more emphasis on earlier cash-flows)
  • allows incorporation of higher risk premium to more risky projects

 

Advantages of NPV compared to IRR

  • NPV considers the size of the investment, while IRR tends to prefer high return percentages irrespective of the absolute amount of investment and return
  • it is easy to incorporate different discount rates to a single NPV calculation, not to IRR (often the case in longer-term projects)
  • NPV is easier to calculate than IRR
  • NPV is based on more realistic assumption that project cash-flows will be reinvested at discount rate (mostly cost of capital), but IRR unrealistically assumes that it will be reinvested at (higher) IRR (32)
  • NPV is more advanced to IRR and shall be thus given priority if the two methods give conflicting decision. However, NPV and IRR most often lead to the same decision. But not always. The reason for differences often resides in uncommon cash-flow distribution (there is negative cash-flow also during the project life, not just at the beginning. The project might then have more IRRs or NPV can increase with increasing IRR (not vice versa as expected). Therefore, IRR can under these circumstances lead to wrong decisions. (32)

Disadvantages of NPV

  • discount rate must be calculated and it can be difficult
  • difficult to explain, specifically in the context of the used discount rate
  • NPV method itself often leads to rejection of low-value projects as these usually have lower NPV than projects with higher value
  • despite of all NPV advantages, IRR is in practice more widely used than NPV

 

SIMPLIFIED NPV PROFORMA

 

The relevant cash-flows DO NOT INCLUDE INTEREST! Otherwise, they would be double counted – once through those interest charges and for the second time through discount factor. (30)

 

ASSUMPTIONS ADOPTED FOR NPV CALCULATION

Assumptions for NPV calculation shall be agreed in advance. The assumptions shall be used consistently and shall include:

  • period to which will the relevant cash-flows be included
  • treatment of tax effects
  • treatment of changes in working capital (inventories, receivables, payables)
  • definition of discount rate

 

Period to which will the relevant cash-flows be included

  • generally:
    • if the cash-flow occurs at the beginning of the period, it shall be covered into (the end) of the previous period
    • if the cash-flow occurs at the end of the period, it shall be covered into that period
    • but if the cash-flow occurs during the period – consistent treatment must be adopted; usually taken to that period
  • it must be decided what will be the starting year (year 1) – it can be purchase of the asset or first cash inflow generated from the project
  • most often, purchase of asset (investment) is placed into the year 0 and it is therefore not discounted (or discounted with discount factor of 1) and first cash inflow generated from the project is placed to year 1
  • tax effects are usually delayed as the taxes are paid in the following year
  • working capital changes usually form part the total investment (investment value is the total of capital expenditure and initial working capital), then change with the changed sales revenues during the project life and reverse at the end of the investment useful life (however, it depends on the project type)

 

Tax effects

Income tax is assessed based on tax profits, therefore income statement items need to be prepared as well as the relevant cash-flows. It is a matter of decision to which level of detail the tax effects will be calculated. But in general, tax charges on profit figures, tax relief resulting from acquired asset´s tax depreciation and the difference obtained from sale of asset at the end of the project and disposal value shall be included.

Income tax is usually (depending on the applicable tax law) payable one year in arrears and it is therefore included in the NPV proforma with one-year delay.

 

Working capital changes (cash to finance additional working capital)

Increased sales usually result in increase of inventory, receivables and payables levels which in total represent cash outflow, and vice versa. It is necessary not to forget about their reversal when sales begin to decrease again. Therefore, working capital changes usually go to zero over the life of the investment. 

 

 

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The following sources were used:

30. Net present value (online).  Citation date: 19.1.2016. Available from www: https://en.wikipedia.org/wiki/Net_present_value

32. Obaidullah Jan, ACA, CFA. NPV vs. IRR (online). Citation date: 19.1.2016. Available from www: http://accountingexplained.com/managerial/capital-budgeting/npv-vs-irr

 



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