Net Present Value (NPV) as a Capital Budgeting Method
Companies often use net present value as a capital budgeting method because it's perhaps the most insightful and useful method to evaluate whether to invest in a new capital project. It is more refined from both a mathematical and time-value-of-money point of view than either the payback period or discounted payback period methods. It is also more insightful in certain ways than the profitability index or internal rate of return calculations.
What Is Net Present Value?
Net present value is one of many capital budgeting methods used to evaluate potential physical asset projects in which a company might want to invest. Usually, these capital investment projects are large in terms of scope and money, such as purchasing an expensive set of assembly-line equipment or constructing a new building.
Net present value uses discounted cash flows in the analysis, which makes the net present value more precise than of any of the capital budgeting methods as it considers both the risk and time variables.
A net present value analysis involves several variables and assumptions and evaluates the cash flows forecasted to be delivered by a project by discounting them back to the present using information that includes the time span of the project (t) and the firm's weighted average cost of capital (i). If the result is positive, then the firm should invest in the project. If negative, the firm should not invest in the project.
Capital Projects Using Net Present Value
Before you can use net present value to evaluate a capital investment project, you'll need to know if that project is a mutually exclusive or independent project. Independent projects are those not affected by the cash flows of other projects.
Mutually exclusive projects, however, are different. If two projects are mutually exclusive, it means there are two ways of accomplishing the same result. It might be that a business has requested bids on a project and a number of bids have been received. You wouldn't want to accept two bids for the same project. That is an example of a mutually exclusive project.
When you are evaluating two capital investment projects, you have to evaluate whether they are independent or mutually exclusive and make an accept-or-reject decision with that in mind.
Net Present Value Decision Rules
Every capital budgeting method has a set of decision rules. For example, the payback period method's decision rule is that you accept the project if it pays back its initial investment within a given period of time. The same decision rule holds true for the discounted payback period method.
Net present value also has its own decision rules, which include the following:
- Independent projects: If NPV is greater than $0, accept the project.
- Mutually exclusive projects: If the NPV of one project is greater than the NPV of the other project, accept the project with the higher NPV. If both projects have a negative NPV, reject both projects.
Say that firm XYZ Inc. is considering two projects, Project A and Project B, and wants to calculate the NPV for each project.
- Project A is a four-year project with the following cash flows in each of the four years: $5,000, $4,000, $3,000, $1,000.
- Project B is also a four-year project with the following cash flows in each of the four years: $1,000, $3,000, $4,000, $6,750.
- The firm's cost of capital is 10 percent for each project, and the initial investment is $10,000.
The firm wants to determine and compare the net present value of these cash flows for both projects. Each project has uneven cash flows. In other words, the cash flows are not annuities.
Following is the basic equation for calculating the present value of cash flows, NPV(p), when cash flows differ each period:
NPV(p) = CF(0) + CF(1)/(1 + i)t + CF(2)/(1 + i)t + CF(3)/(1 + i)t + CF(4)/(1 + i)t
- i = firm's cost of capital
- t = the year in which the cash flow is received
- CF(0) = initial investment
To work the NPV formula:
- Add the cash flow from Year 0, which is the initial investment in the project, to the rest of the project cash flows.
- The initial investment is a cash outflow, so it is a negative number. In this example, the cash flows for each project for years 1 through 4 are all positive numbers.
Tip: You can extend this equation for as many time periods as the project lasts.
To calculate the NPV for Project A:
NPV(A) = (-$10,000) + $5,000/(1.10)1 + $4,000/(1.10)2 + $3,000/(1.10)3 + $1,000/(1.10)4
The NPV of Project A is $788.20, which means that if the firm invests in the project, it adds $788.20 in value to the firm's worth.
Although NPV offers insight and a useful way to quantify a project's value and potential profit contribution, it does have its drawbacks. Since no analyst has a crystal ball, every capital budgeting method suffers from the risk of incorrectly estimated critical formula inputs and assumptions, as well as unexpected or unforeseen events that can affect a project's costs and cash flows.
The NPV calculation relies on estimated costs, an estimated discount rate, and estimated projected return. It also can't factor in unforeseen expenses, time delays, and any other issues that come up on the front or back end, or during the project.
Also, the discount rate and cash flows used in an NPV calculation often don't capture all of the potential risks, assuming instead the maximum cash flow values for each period of the project. This leads to a false sense of confidence for investors, and firms often run different NPV scenarios using conservative, aggressive, and most-likely sets of assumptions to help mitigate this risk.
Alternative Evaluation Methods
In some cases, especially for short-term projects, simpler methods of evaluation make sense. The payback-period method calculates how long it will take to earn back the project's initial investment. Although it doesn't consider profits that come in once the initial costs are paid back, the decision process might not need this component of the analysis. The method only makes sense for short-term projects because it doesn't consider the time value of money, which renders it less effective for multiyear projects or inflationary environments.
The internal rate of return (IRR) analysis is another often-used option, although it relies on the same NPV formula. IRR analysis differs in that it considers only the cash flows for each period and disregards the initial investment. Additionally, the result is derived by solving for the discount rate, rather than plugging in an estimated rate as with the NPV formula.
The IRR formula result is on an annualized basis, which makes it easier to compare different projects. The NPV formula, on the other hand, gives a result that considers all years of the project together, whether one, three, or more, making it difficult to compare to other projects with different time frames.