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Net Present Value

The document explains the concept of Net Present Value (NPV) and its importance in assessing investment projects by discounting future cash flows to their present value. It emphasizes that money loses value over time due to inflation and that a positive NPV indicates a viable project. The choice of discount rate is crucial, reflecting the cost of capital and opportunity costs associated with financing investments.

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3 views

Net Present Value

The document explains the concept of Net Present Value (NPV) and its importance in assessing investment projects by discounting future cash flows to their present value. It emphasizes that money loses value over time due to inflation and that a positive NPV indicates a viable project. The choice of discount rate is crucial, reflecting the cost of capital and opportunity costs associated with financing investments.

Uploaded by

kejinw161
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 9

NET PRESENT

VALUE
Because “It’s all about the money, money, money!”
Let’s establish some “Fast Facts”
here:

Inflation Relation to Interest


Over time, money DCF Cash
Discounted Rate an
Henceforth,
loses its value (i.e., Flows (DCF) taught interest rate or a
its purchasing us that cash flows discount rate is
power) due to should be used to determine
inflation. Consider discounted to the loss of value of
that $100 today is accommodate for the money to be
not what it was changes in the received in the
worth 10 years ago. value of future future.
cash inflows.
The Bottom
Line:
Let’s just be honest. Let’s just be
real:
DCF/NPV is based on the
principle that profits to be
received on investment projects
is always in the future and
money paid or earned in the
future is worth less than if it was
earned today!!!

A fixed sum of money paid in


the future is less than a fixed
sum paid today!!!!!
Consider
If you This:
put $100 in a bank account
today and earn 5%, then in one year’s
time your money would have grown
in value to $105 ($100 + $5.00
interest).
On this basis your original $100 is
therefore now only worth 95% of its
value in a year’s time. This means
that the Present Value of money
($100.00) in year 2 has fallen by 5%.
DEFINITION
According to the Harvard Business Review,
“Net present value is the present value of the
cash flows at the required rate of return of
your project compared to your initial
investment,” says Knight. In practical terms, it’s
a method of calculating your return on
investment, or ROI, for a project or
expenditure. By looking at all of the money
you expect to make from the investment and
translating those returns into today’s dollars,
you can decide whether the project is
THE NECESSARY
COMPONENTS
Projecte
Discount Criterion
An alternative
d Cash Time
by Factor
This is the rate
which future Rate
approach to Flows Frame
selecting the This refers to
cash flows will The accuracy
discount rate is for how long the
be discounted. of projected
a business to adopt project/
There are cash flows is
a cut-off or investment is
multiple ways important.
criterion rate. The expected to
of doing this, Otherwise,
business would use yield returns.
but it’s incorrect
this to discount the
generally based determinations
returns on a
on the cost of can be made
project and, if the
borrowing the about the
net present value is
capital to returns of a
positive, the
finance the project.
FORMULA
WORKED EXAMPLE

The Net Present Value is now calculated as: NPV = Total DCF – Initial
Cost of Investment

In the example, this gives: Total Discounted Cash Flows $ 11,940


Less Investment Outlay $ 10,000
NPV $ 1,940
This project is viable at a discount rate of 8% because the NPV is
DISCOUNT RATE’S
SIGNIFICANCE
The choice of discount rate is, therefore, crucial to the
assessment of projects using this method of appraisal.
Usually, businesses will choose a rate of discount that
reflects the cost of borrowing the capital to finance the
investment. Even if the finance is raised internally, the
rate of interest should still be used to discount future
returns. This is because of the opportunity cost of
internal finance – it could be used to gain prevailing rate
of interest if left o deposit in the bank.

An alternative approach to selecting the discount rate is


to be use for business is to adopt a cut-off or criterion
rate. The business would use this to discount returns on
projects and, if the NPV is positive the project will go

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