Escolar Documentos
Profissional Documentos
Cultura Documentos
Net present value (NPV) is a standard method for the financial appraisal of long-term projects. Used for capital budgeting, and widely throughout economics, it measures the excess or shortfall of cash flows, in present value (PV) terms, once financing charges are met. By definition, NPV = Present value of net cash flows. For its expression, see the formula section below.
Contents
1 Formula 2 The Discount Rate 3 What NPV Means 4 Example 5 Common Pitfalls 6 Alternative capital budgeting methods 7 Applications of NPV 8 See also 9 References
Formula
Each cash inflow/outflow is discounted back to its present value (PV). Then they are summed. Therefore:
or shortened: Where: t - the time of the cash flow N - the total time of the project r - the discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.) Ct - the net cash flow (the amount of cash) at time t (for educational purposes, C0 is commonly placed to the left of the sum to emphasize its role as the initial investment.). For more information on how to calculate the PV of a dollar or of a stream of payments, see time value of money.
alternatives, the one yielding the higher NPV should be selected. The following sums up the NPVs in various situations. If... It means... Then... NPV the investment would the project may be accepted >0 add value to the firm the investment would NPV subtract value from the project should be rejected <0 the firm We should be indifferent in the decision whether to accept or the investment would NPV reject the project. This project adds no monetary value. Decision neither gain nor lose =0 should be based on other criteria, e.g. strategic positioning or value for the firm other factors not explicitly included in the calculation. However, NPV = 0 does not mean that a project is only expected to break even, in the sense of undiscounted profit or loss (earnings). It will show net total positive cash flow and earnings over its life.
Example
X corporation must decide whether to introduce a new product line. The new product will have startup costs, operational costs, and incoming cash flows over six years. This project will have an immediate (t=0) cash outflow of $100,000 (which might include machinery, and employee training costs). Other cash outflows for years 1-6 are expected to be $5,000 per year. Cash inflows are expected to be $30,000 per year for years 1-6. All cash flows are aftertax, and there are no cash flows expected after year 6. The required rate of return is 10%. The present value (PV) can be calculated for each year: T=0 -$100,000/ 1.100 = -$100,000 PV. T=1 ($30,000 - $5,000) / 1.101 = $22,727 PV. T=2 ($30,000 - $5,000) / 1.102 = $20,661 PV. T=3 ($30,000 - $5,000) / 1.103 = $18,783 PV. T=4 ($30,000 - $5,000) / 1.104 = $17,075 PV. T=5 ($30,000 - $5,000) / 1.105 = $15,523 PV. T=6 ($30,000 - $5,000) / 1.106 = $14,112 PV. The sum of all these present values is the net present value, which equals $8,881. Since the NPV is greater than zero, the corporation should invest in the project. The same example in an Excel formulae:
More realistic problems would need to consider other factors, generally including the calculation of taxes, uneven cash flows, and salvage values as well as the availability of alternate investment opportunities.
Common Pitfalls
If some (or all) of the Ct have a negative value, then paradoxical results are possible. For example, if the Ct are generally negative late in the project (eg, an industrial or mining project might have clean-up and restoration costs), then an increase in the discount rate can make the project appear more favourable. Some people see this as a problem with NPV. A way to avoid
this problem is to include explicit provision for financing any losses after the initial investment, ie, explicitly calculate the cost of financing such losses. Another common pitfall is to adjust for risk by adding a premium to the discount rate. Whilst a bank might charge a higher rate of interest for a risky project, that does not mean that this is a valid approach to adjusting a net present value for risk, although it can be a reasonable approximation in some specific cases. One reason such an approach may not work well can be seen from the foregoing: if some risk is incurred resulting in some losses, then a discount rate in the NPV will reduce the impact of such losses below their true financial cost. A rigorous approach to risk requires identifying and valuing risks explicitly, e.g. by actuarial or Monte Carlo techniques, and explicitly calculating the cost of financing any losses incurred. Yet another issue can result from the compounding of the risk premium. R is a composite of the risk free rate and the risk premium. As a result, future cash flows are discounted by both the risk free rate as well as the risk premium and this effect is compounded by each subsequent cash flow. This compounding results in a much lower NPV than might be otherwise calculated. The certainty equivalent model can be used to account for the risk premium without compounding its effect on present value.
payback period: which measures the time required for the cash inflows to equal the original outlay. It measures risk, not return. cost-benefit analysis: which includes issues other than cash, such as time savings. real option method: which attempts to value managerial flexibility that is assumed away in NPV. internal rate of return (IRR): which calculates the rate of return of a project without making assumptions about the reinvestment of the cash flows (hence internal) modified internal rate of return (MIRR): similar to IRR, but it makes explicit assumptions about the reinvestment of the cash flows. Sometimes it is called Growth Rate of Return.
Applications of NPV
Using NPV to calculate share prices. Calculating Net Present Value. PV web calculator
See also
Debt overhang Capital budgeting Cost of capital Discounted cash flow Enterprise value Internal rate of return Rate of return on investment Real versus nominal value Terminal value (finance)
References
1. ^ Baker, Samuel L. (2000). Perils of the Internal Rate of Return. Retrieved on Jan 12, 2007. Retrieved from "http://en.wikipedia.org/wiki/Net_present_value" Categories: Basic financial concepts | Mathematical finance | Investment
This page was last modified on 26 March 2008, at 19:26. All text is available under the terms of the GNU Free Documentation License. (See Copyrights for details.) Wikipedia is a registered trademark of the Wikimedia Foundation, Inc., a U.S. registered 501(c)(3) tax-deductible nonprofit charity.