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Net Present Value (NPV)

Net present value is one of the most reliable measure used in capital budgeting. It is
the present value of net cash inflows generated by a project less the initial investment
on the project. The use of discounted cash inflows means that net present value
accounts for time value of money. Before calculating NPV, a target rate of return is set
which is used to discount the net cash inflows from a project.
Calculation Methods and Formulas
The major component of NPV is the present value of net cash inflows which may be
even (i.e. equal cash inflows in different periods) or uneven (i.e. different cash flows in
different periods). Where net cash inflows are even, present value can be easily
calculated by using the present value formula of annuity. However if net cash inflows
are uneven we need to calculate the present value of each individual cash inflow
separately. Thus we have two formulas for the calculating of NPV:
When cash inflows are Even:
NPV = R
1 ( 1 + i )
-n

Initial Investment
i
In the above formula,
R is the net cash inflow expected to be received each period;
i is the required rate of return per period;
n are the number of periods during which the project is expected to operate and
generate cash inflows.
When cash inflows are uneven:
NPV =
R1
+
R2
+
R3
+ ... Initial Investment
( 1 + i )
1
( 1 + i )
2
( 1 + i )
3

Where,
i is the target rate of return per period;
R
1
is the net cash inflow during the first period;
R
2
is the net cash inflow during the second period,
R
3
is the net cash inflow during the third period, and so on ...
Decision Rule
Accept the project if its NPV is positive. Reject the project having negative NPV. While
comparing two or more exclusive projects, all having positive NPV, accept the one with
highest NPV.
Examples
Example 1: Even Cash Inflows Calculate the net present value of a project which
requires an initial investment of $243,000 and it is estimated to generate a cash inflow
of $50,000 each month for 12 months. Assume that the salvage value of the project is
zero. The target rate of return is 12% per annum.
Solution
We have,
Initial Investment = $243,000
Cash Inflow per Period = $50,000
Number of Periods = 12
Discount Rate per Period = 12% 12 = 1%

Net Present Value
= $50,000 ( 1 ( 1 + 1% )^-12 ) 1% $243,000
= $50,000 ( 1 1.01^-12 ) 0.01 $243,000
$50,000 ( 1 0.887449) 0.01 $243,000
$50,000 0.112551 0.01 $243,000
$50,000 11.2551 $243,000
$562,754 $243,000
$319,754
Example 2: Uneven Cash Inflows An initial investment on plant and machinery of
$8,320 thousand will generate cash inflows of $3,411 thousand, $4,070 thousand,
$5,824 thousand and $2,065 thousand in first, second, third and fourth year
respectively. At the end of the fourth year the machinery will become obsolete and will
be sold for $900 thousand. Calculate the present value of the investment if the discount
rate is 18%. Round your answer to nearest thousand dollars.
Solution
PV Factor, Year 1 = 1 / ( 1 + 18% )^1 0.8475
PV Factor, Year 2 = 1 / ( 1 + 18% )^2 0.7182
PV Factor, Year 3 = 1 / ( 1 + 18% )^3 0.6086
PV Factor, Year 4 = 1 / ( 1 + 18% )^4 0.5158
The rest of the problem can be more efficiently solved in table format:

Advantage and Disadvantage of NPV
Advantage: Net present value accounts for time value of money. Thus it is more
reliable than other investment appraisal techniques such payback period and
accounting rate of return. Also it is fairly easy to calculate.
Disadvantage: It is based on estimated future cash flows of the project and estimates
may be far from actual results.

http://accountingexplained.com/managerial/capital-budgeting/npv


Net Present Value
Economists focus much of their analyses on a marketplace
where supply and demand are based on the perceptions of
present value and scarcity. However, when going beyond the
simplicity of the short-term, particularly when costs and benefits
occur at different points in time, it is important to
utilize discounting to undertake longer-term analyses.
Discounting adjusts costs and benefits to a common point in
time. This approach can be useful in helping to determine how
best to utilize many of our non-renewable natural resources.
Net present value (NPV) is a calculation used to estimate the
value ? or net benefit ? over the lifetime of a particular project,
often longer-term investments, such as building a new town hall
or installing energy efficient appliances. NPV allows decision
makers to compare various alternatives on a similar time scale
by converting all options to current dollar figures. A project is
deemed acceptable if the net present value is positive over the
expected lifetime of the project.
The formula for NPV requires knowing the likely amount of time
(t, usually in years) that cash will be invested in the project, the
total length of time of the project (N, in the same unit of time
as t), the interest rate (i), and the cash flow at that specific
point in time (cash inflow ? cash outflow, C).

For example, take a business that is considering changing their
lighting from traditional incandescent bulbs to fluorescents. The
initial investment to change the lights themselves would be
$40,000. After the initial investment, it is expected to cost
$2,000 to operate the lighting system but will also yield $15,000
in savings each year; thus, there is a yearly cash flow of
$13,000 every year after the initial investment. For simplicity,
assume a discount rate of 10% and an assumption that the
lighting system will be utilized over a 5 year time period. This
scenario would have the following NPV calculations:
t = 0 NPV = (-40,000)/(1 + .10) 0 = -40,000.00
t = 1 NPV = (13,000)/(1.10) 1 = 11,818.18
t = 2 NPV = (13,000)/(1.10) 2 = 10,743.80
t = 3 NPV = (13,000)/(1.10) 3 = 9,767.09
t = 4 NPV = (13,000)/(1.10) 4 = 8,879.17
t = 5 NPV = (13,000)/(1.10) 5 = 8,071.98
Based on the information above, the total net present value over
the lifetime of the project would be $9,280.22.
Once the net present value is calculated, various alternatives
can be compared and/or choices can be made. Any proposal
with a NPV < 0 should be dismissed because it means that a
project will likely lose money or not create enough benefit. The
clear choice is a project whose NPV > 0 or, if there are several
alternatives with positive NPVs, the choice would be the
alternative with the higher NPV. With most societal choices,
the opportunity costs are also considered when making
decisions. Net present value provides one way to minimize
foregone opportunities and identify the best possible options.
This particular example assumes that the interest rate does not
change over time. Longer periods of time will often require
separate calculations for each year in order to adjust for
anticipated changes in the interest rate. When discounting is
used it takes into account the fact that benefits in the future are
not expected to be worth as much as in the present time. For
example, $10 today may only be worth $9, $5, or even $1 in
2025. The rationale behind using a discount rate is two-fold: all
things being equal, (1) individuals prefer to benefit now rather
than later and (2) they tend to be risk averse, uncertain of what
will occur in the future.
Net present value calculations can also help account for
depreciation. Over time most assets depreciate, or lose value.
Companies or individuals must be able to calculate a rate that
includes depreciation for account balancing and tax purposes, as
well to help predict replacement times for the asset in question.
NPV and depreciation calculations are extremely valuable in the
world of economics; they tell us what projects and businesses
are better investments and what outcomes we may expect in
the future.
However, while depreciation rates can be reliably estimated for
most physical items, such as computer equipment or buildings,
their application to natural resources and other environmental
issues is more uncertain. Natural resources do not necessarily
lose value over time. Thus, in most cases natural resources
should not be depreciated when calculating resource NPVs. Also,
since there is uncertainty about the future and external effects
exist, it is much easier to predict what a company can do and
what the reaction will be in the structured world of business
than to accurately assess, say, the value of a forest to a local
economy in future years.
Despite how helpful calculating NPV can be, using it to assess
projects related to the environment will continue to be
controversial. Ecosystem valuation is a complex process that
does not always result in the assignment of accurate values to
natural resources. And, while the use of discounting may make
sense for money ? being not as valuable in the future as it is
today ? it may be more difficult to use in assessing natural
resources. Since many natural resources often increase in value,
this type of evaluation method would need to recognize
increased future resource values and/or that of other
environmental services.

http://www.enviroliteracy.org/article.php/1335.html

Performing a Cost-Benefit Analysis
By Stanley E. Portny from Project Management For Dummies, 3rd Edition
Whether you know it as a cost-benefit analysis or a benefit-cost analysis, performing
one is critical to any project. When you perform a cost-benefit analysis, you make a
comparative assessment of all the benefits you anticipate from your project and all the
costs to introduce the project, perform it, and support the changes resulting from it.
Cost-benefit analyses help you to
Decide whether to undertake a project or decide which of several projects to
undertake.
Frame appropriate project objectives.
Develop appropriate before and after measures of project success.
Prepare estimates of the resources required to perform the project work.
Everything gets a dollar value in a cost-benefit analysis
You can express some anticipated benefits in monetary equivalents (such as reduced
operating costs or increased revenue). For other benefits, numerical measures can
approximate some, but not all, aspects. If your project is to improve staff morale, for
example, you may consider associated benefits to include reduced turnover, increased
productivity, fewer absences, and fewer formal grievances. Whenever possible,
express benefits and costs in monetary terms to facilitate the assessment of a projects
net value.
Consider costs for all phases of the project. Such costs may be nonrecurring (such as
labor, capital investment, and certain operations and services) or recurring (such as
changes in personnel, supplies, and materials or maintenance and repair). In addition,
consider the following:
Potential costs of not doing the project
Potential costs if the project fails
Opportunity costs (in other words, the potential benefits if you had spent your
funds successfully performing a different project)
Cost-benefit analysis: Weighing future values today
The farther into the future you look when performing your analysis, the more
important it is to convert your estimates of benefits over costs into todays dollars.
Unfortunately, the farther you look, the less confident you can be of your estimates.
For example, you may expect to reap benefits for years from a new computer system,
but changing technology may make your new system obsolete after only one year.
Thus, the following two key factors influence the results of a cost-benefit analysis:
How far into the future you look to identify benefits
On which assumptions you base your analysis
Although you may not want to go out and design a cost-benefit analysis by yourself,
you definitely want to see whether your project already has one and, if it does, what
the specific results of that analysis were.
The net present value (NPV) is based on the following two premises:
Inflation: The purchasing power of a dollar will be less one year from now
than it is today. If the rate of inflation is 3 percent for the next 12 months, $1
today will be worth 97 cents just 12 months from today. In other words, 12
months from now, youll pay $1 to buy what you paid 97 cents for today.
Lost return on investment: If you spend money to perform the project being
considered, youll forego the future income you could earn by investing it
conservatively today. For example, if you put $1 in a bank and receive simple
interest at the rate of 3 percent compounded annually, 12 months from today
youll have $1.03 (assuming zero-percent inflation).
To address these considerations when determining the NPV, you specify the following
numbers:
Discount rate: The factor that reflects the future value of $1 in todays dollars,
considering the effects of both inflation and lost return on investment
Allowable payback period: The length of time for anticipated benefits and
estimated costs
In addition to determining the NPV for different discount rates and payback periods,
figure the projects internal rate of return for each payback period.
http://webcache.googleusercontent.com/search?q=cache:http://www.dummies.com/how-
to/content/performing-a-costbenefit-analysis.html

Cost / Benefit AnalysisAuthors: Dr. Brian Slack and Dr. Jean-Paul Rodrigue1. The
FrameworkCost-benefit analysis (CBA or COBA) is a major tool employed to evaluate
projects. It provides the researcher or the planner with a set of values that are useful to
determine the feasibility of a project from and economic standpoint. Conceptually simple, its
results are easy for decision makers to comprehend, and therefore enjoys a great deal of favor in
project assessments. The end product of the procedure is a benefit/cost ratio that compares the
total expected benefits to the total predicted costs. In practice CBA is quite complex, because it
raises a number of assumptions about the scope of the assessment, the time-frame, as well as
technical issues involved in measuring the benefits and costs.Before any meaningful analysis can
be pursued, it is essential that an appropriate framework be specified. An extremely important
issue is to define the spatial scope of the assessment. Transport projects tend to have negative
impacts over short distances from the site, and broader benefits over wider areas. Thus extending
a runway may impact severely on local residents through noise generation, and if the evaluation
is based on such a narrowly defined area, the costs could easily outweigh any benefits. On the
other hand defining an area that is too broad could lead to spurious benefits. The aim of the
study area definition should be to include all parts of the transport network which are likely to
include significant changes in flow, cost or time as a result of the project (UN 2003,
17).Because transport projects have long term effects, and because the analysis is carried out on
a real term basis, the benefits and costs must be assessed using specific and pre-determined
parameters. For example: when is the project start date, when will it be completed, over what
period of time will the appraisal run, and what discount rate will be used to depreciate the value
of the costs and benefits over the appraisal period? These and other parameters must be agreed
upon. Costs and benefits are presented in nominal values, i.e. monetary values of the start year
and discounted for inflation over the project period. Because most transport projects are assessed
for a 30 year period employing different discount rates may influence greatly the outcomes.2.
Costs and BenefitsCosts associated with the project are usually easier to define and measure than
benefits. They include both investment and operating costs. Investment costs include the
planning costs incurred in the design and planning, the land and property costs in acquiring the
site(s) for the project, and construction costs, including materials, labor, etc. Operating costs
typically involve the annual maintenance costs of the project, but may include additional
operating costs incurred, as for example the costs of operating a new light rail
system.Benefits are much more difficult to measure, particularly for transport projects, since
they are likely to be diffuse and extensive. Safety is a benefit that needs to be assessed, and while
there are complex issues involved, many CBA studies use standard measures of property savings
per accident avoided, financial implications for reductions in bodily injury or deaths for
accidents involving people. For example, Transport Canada uses $1.5 million in 1991 dollars for
each fatality saved. One of the most important sets of benefits are efficiency gains as a result of
the project. These gains might be assessed by estimating the time savings or increased capacity
made possible by the project.Many other elements relating to social impacts, aesthetics, health
and the environment are more difficult to assess. The latter, in particular, is a major factor in
contemporary project assessment, and usually separate environmental impact analyses are
required. Where possible these factors must be considered in CBA, and a variety of measures are
used as surrogates for environmental benefits and costs. For example, the commercial losses of
habitat destruction and property damage can be estimated. For example, the difference in the
values of properties adjacent to airports and those further away are used to assess the costs of
noise.3. Results and BiasesThree separate measures are usually obtained from CBA to aid
decision making:
Net Present Value (NPV): This is obtained by subtracting the discounted costs
and negative effects from the discounted benefits. A negative NPV suggests
that the project should be rejected because society would be worse off.
Benefit-cost ratio: This is derived by dividing the discounted costs by the
discounted benefits. A value greater than 1 would indicate a useful project.
Internal rate of return (IRR): The average rate of return on investment costs
over the life of the project.
The first two are broadly similar, though with significant differences. A project may have a high
B/C ratio but still generate a smaller NPV. The results should be subjected to a sensitivity
analysis. This would include considering the robustness of the predictions of costs and benefits,
and usually involves the identification of aspects that would introduce uncertainty into the
predictions. If certain elements are shown to be subject to variations (inflation, higher fuel
charges etc.) various scenarios would be prepared, and the cost/benefit values re-
evaluated.Results in cost / benefit analyses tend to be notoriously inaccurate, as large
infrastructure projects systematically have high cost overruns. An enduring bias concerns the
underestimation of costs and the exaggeration of benefits, which questions the usefulness and
relevance of cost / benefit analysis. A major factor behind this bias is the inherent propensity for
infrastructure promoters to portray projects as highly beneficial for the costs involved in order to
secure approval and funding. To make matters worst, the projects that have the most exaggerated
benefits and the highest cost overruns tend to generate much lower benefits than expected.

http://people.hofstra.edu/geotrans/eng/methods/ch9m1en.html