Net Present Value (NPV) Explained!
Created on 19 Mar 2021
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You Can Second-Guess The Future!! Sounds unbelievable, right? But it isn't. At least in the extraordinary world of finance. Today, finance has evolved to such a stage where any decision related to money can be taken with proper analysis.
One such beneficial financial tool to estimate the future of your investment is Net Present Value. Let's take a look at this tool and know its meaning and importance.
What is Net Present Value (NPV)?
As the name suggests, NPV is the present value of net cash inflows (inflows - outflows) over time. It is widely used in finance as a tool of cash flow analysis. It is used to analyse the expected profitability of an investment, which is used in capital budgeting and investment planning.
It is an all-encompassing metric that accounts for all revenues, expenses, and capital costs associated with an investment in its Free Cash Flows. Besides these, it also considers the timing of each cash flow that can have a substantial impact on the present value of the investment. It is, obviously, better to have cash inflows earlier than cash outflows, rather than vice-versa. And NPV helps you make an estimate of this.
Why is NPV crucial?
You might know that inflation is an inevitable evil. The money you have today won't be worth the same in the future. The best example is petrol, which went from Rs. 72 to Rs. 91 in just a year! A massive 26.4% inflation, much better than many investments. Just like petrol, all commodities get expensive over time. That is why a rupee today is worth more than the same rupee in future.
Let's understand it with an example. If you are given the option to receive Rs. 1000 today or Rs. 1040 after one year, what will you choose? Some of you would choose the latter option. But what if we tell you that the same Rs. 1040 will be worth Rs. 990 as of today (Assuming inflation to be 5%). A wise investor would have chosen the first option and invested it to earn more than 5% returns to increase his wealth.
That is why it is essential to know the Net Present Values of different investment options to assess their returns. Determining the NPVs helps in making sound investment decisions by investors and companies.
How to Calculate NPV?
Now that you know how essential NPV is let's see how to calculate it.
Rt = Net cash inflows - outflows during a single period t
i = Expected Returns earned in alternative investments
t = Time period
In simple words, it is the difference between today's value of expected cash flows and that of invested cash. Let's understand it step-by-step with an example.
Suppose a company invests Rs. 10 Lakhs in a project which will generate annual revenue of Rs. 3,00,000 for five years. Or the company can invest in equity which will give expected returns of 8% annually. And both options have the same risks.
Step 1: NPV of initial investment: The initial investment (outflow) is made in the present. So there is no need to discount this value. The investment in the project will generate annual cash flows for five years. So the time period (t) is 5. The equity investment has 8% expected annual return (i).
Step 2: NPV of future cash flows: Assuming the cash flows to be earned at the end of the year, it is to be discounted to know the present value. It comes to Rs. 11,97,813 (Using a Net Present Value Calculator). Thus, NPV is Rs. 1,97,813 (11,97,813 - 10 Lakhs).
In this case, the NPV of future cash flows is positive. So it will be better to invest in the project. If NPV was negative due to lesser cash flows or higher discount rates, it would be advisable to avoid investing in the project. And invest in equity in such a situation.
You might think that this method is free from defects as only the present values are taken into account. But the drawbacks lie in its core only, which are as follows:
- Assumptions: Calculating the discount rate or the future cash flows lies heavily on assumptions, which creates room for arithmetical error. Unforeseen circumstances or wrong assumptions can make all your efforts go in vain.
- Other factors ignored: NPV method only considers quantitative factors. But vital qualitative characteristics are ignored in this method.
- Difficult comparison: If different projects have different life spans of cash flows, it becomes difficult to compare them. E.g., A project having cash inflows for five years and a project having cash inflows for ten years are not comparable.
- Complex: For a lay-man, it becomes complex if they don't know how to use the required MS-Excel functions or NPV calculators.
After knowing the drawbacks of the NPV method, let us tell you about an alternate method that is relatively simpler to understand.
Internal Rate of Return (IRR) is a method to analyse the effectiveness of investment. It is the discount rate at which NPV is zero. It helps in knowing the minimum returns you should get to break-even. It can compare investment options with different life spans or different amounts of the initial investment.
It helps in making a sound investment decision. If the investment gives you a higher return than IRR, GO FOR IT! Or else reject it.
The Bottom Line
To wrap it up, Net Present Value is the present value of net cash flows. It is used in many financial decisions. It is essential to consider the time value of money, as money loses its worth over time. It is the difference between the present value of future cash inflows and the present value of the initial investment. Although it is a good analysis tool, it has various drawbacks. It includes making assumptions, difficult comparisons, and ignoring some vital factors. An easier alternative to NPV is IRR, which helps in finding the minimum returns required to have an NPV of zero.
In the end, remember that the best present you have is 'the present.' So, be wise enough to also consider your present situation and financial position before making any decision, whether investment or otherwise.
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