A Report on Importance of NPV as evaluation criteria

Prepared by : NAME: Asfak Vhora Chirag Mandaliya Enr. No. 117920592019 117920592021

NPV (Net Present Value) Net Present value is the classic economic method of evaluating the investment proposals. Its DCF (Discounted Cash flow) technique that explicitly recognizes the time value of money. Net present value method use for calculating and estimating long term investments total costs and benefits, which is comes under the head of Capital Budgeting. So, we first get some basic knowledge of Capital Budgeting.

Capital budgeting : Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. Itis budget for major capital, or investment, expenditures. Many formal methods are used in capital budgeting, including the techniques such as

Accounting rate of return Payback period Net present value Profitability index Internal rate of return

Capital budgeting is vital in marketing decisions. Decisions on investment, which take time to mature, have to be based on the returns which that investment will make. Unless the project is for social reasons only, if the investment is unprofitable in the long run, it is unwise to invest in it now.

Often, it would be good to know what the present value of the future investment is, or how long it will take to mature (give returns). It could be much more profitable putting the planned investment money in the bank and earning interest, or investing in an alternative project. An efficient allocation of capital is the most important finance function in the modern times. It involves decisions to commit the firms fund to long term assets. Capital Budgeting or investment decisions are of considerable importance to the firm, since they tend to determine its value by influencing its growth, profitability and risk. Capital budgeting is also known as investment decisions or capital expenditure decisions. A capital budgeting decisions may be defined as the firms decision to invest its current funds most efficiently in the long-term assets in anticipation of an expected floe of benefits over a series of years. Now we are discussing our main topic i.e. Net Present Value

Net Present Value Analysis:

Atraditional analysis of a projects long-term costs and benefits simply adds together each years cost or benefit so that the total cost is the sum of the costs in each year, and the total benefit is the sum of the benefits in each year. Subtracting the total cost from the total benefit calculates a projects total net benefit. The flaw of the traditional method of analysis is that it assumes that dollars in future years have the same value as dollars today and can simply be added together. Although a traditional analysis gives dollars in the future the same value as dollars today, governments, and society as a whole, implicitly place a lower value on future dollars than current dollars, a concept known as the time value of money. One simple example that proves this is a savings bond. A $100 savings bond that matures in 10 years represents $100 in the future, however, it is worth much less than a $100 bill today.

Governments also place a higher value on dollars today rather than dollars in the future. Many governments are willing to pay an interest cost to borrow money to finance capital projects. Instead of paying an interest cost to borrow money, a government could have saved money year by year to meet future capital needs. The fact that a government chose to spend its revenue on current rather than future needs (and pay an interest cost down the road) proves that it places a higher value on current rather than future needs. Since traditional analysis gives a mistakenly high value to dollars in the future, it may provide poor information. In traditional analysis of capital projects, money in the future is given the same value as money today; but as proven above, money in the future is given a lower value than money today. Thus, traditional analysis may provide an estimate that is inconsistent with a decision-makers criteria.

Net present value analysis closely matches the criteria that governments implicitly use when making long-term decisionsmeaning that it gives a lower value to dollars in the future. Instead of simply adding together each years cost or benefit, net present value analysis first converts the value of future costs and benefits to their actual value today. This is like converting the value that is written on the face of a savings bond to its actual value today. After converting each years

future value to a present value, the net benefits for each year are summed to calculate the total net benefit. To convert future dollars to present dollars, net present value analysis uses a number called a discount rate. A discount rate reflects a governments cost of borrowing or a communitys preference for present versus future consumption. Although there is no standard government discount rate, the interest rates in the nations financial markets are a good source for determining a discount rate.

How to Do a NPV Analysis Net present value analysis involves four basic steps. 1. 2. 3. 4. The first step is to forecast the benefits and costs in each year. The second step is to determine a discount rate. The third step is to use a formula to calculate the net present value. The final step is to compare the net present values of the alternatives.

Step 1: For each alternative, forecast the benefits and costs in each year. To begin, forecast the total benefits and total costs in each year. A typical forecast of costs and benefits might look something like Exhibit 1. In this example, the government would incur large upfront costs but enjoy a stream of benefits in later years. Making accurate forecasts of future costs and benefits can be the most difficult step in net present value analysis. Analysts should follow five general rules when forecasting costs and benefits. 1) Forecast benefits and costs in todays dollars. 2) Do not include sunk costs. 3) Include opportunity costs. 4) Use expected value to estimate uncertain benefits and costs. 5) Omit non-monetary costs and benefits.

Step 2: Determine the discount rate. The discount rate converts the stream of future costs and benefits into their value today. For a private firm, the discount rate is simply the rate of return on an investment with a similar risk as the proposed project. Unfortunately, there is no consensus on how governments should determine their discount rate. The author prefers to use a different discount rate for projects that are primarily financed with taxes and projects that are primarily financed with bonds. Tax-financed projects should have a discount rate that is different from bond financed projects because tax financing displaces private consumption, whereas bond financing mostly displaces private investment.

Step 3: Calculate the net present value of each alternative. Here we have to calculate a net present value for each alternative. First, combine the benefits and costs in each year to produce a net benefit for that year. Second, plug the net benefit of each year into the formula below it. Third, solve the formula to calculate the net present value for the alternative. Step 4: Determine which alternative has the highest net present value. After calculating a net present value for each alternative, determine which alternative has the highest net present value. If only monetary costs and benefits were included in the calculation, then consider whether the non-monetary costs and benefits justify selecting another alternative. Acceptance rules of NPV: Accept the project when NPV is positive. NPV>0 Reject the project when NPV is negative. NPV<0 May accept the project when NPV is Zero. NPV=0

The formula for the net present value :

NPV =

[{C1/(1+k)1} + {C2/(1+k)2} +{C3/(1+k)3} +.+{Cn/(1+k)n}]- C0

/(1+k)t C0

= Ct

Where,
Cn = presrnt net cash flows in each year C0 = is the intial cost of the investment K = cost of capital ( Interest rate) Example:
Assume that project X costs Rs. 2500 now and is expected to generate yearend cash inflows of Rs 900, Rs 800, Rs 700, Rs 600 and Rs 500 in 1 year through 5. The opportunity cost of the capital may be assumed to be 10 percent. The net present value for Project X can be calculated by referring to the present value table or by calculator. In this example our initial investment for the project X i.e. C0 = 2500 and our k is 10 %, now we calculate NPV for the project X.

NPV =

[{C1/(1+k)1} + {C2/(1+k)2} + {C3/(1+k)3}

{C4/(1+k)4} + {C5/(1+k)5}]- C0

[{900/(1+0.10)1} + {800/(1+0.10)2} +
{700/(1+0.10)3} + {600/(1+0.10)4} + {500/(1+0.10)5}]- 2500
= [900(PVF1,0.10) + 800(PVF2,0.10) + 700(PVF3,0.10) + 600(PVF4,0.10) + 500(PVF5,0.10)]-2500
= [900*0.909 + 800*0.826 + 700*0.751 + 600*0.683 +500*0.620] - 2500 = 2725 2500 = Rs. 225

Project Xs present value of cash inflows ( RS. 2725 ) is greater than that of cash outflows ( Rs. 2500 ). Thus, it generates a positive net present value i.e. Rs. 225. So we can say that Project X adds to the wealth of owners: therefore, it should be accepted.