Net Present Value (NPV) as a Capital Budgeting Method
What is Net Present Value and How is it Used in Capital Budgeting?
Net present value is a capital budgeting method that is likely the most correct capital budgeting method that business owners can use in evaluating whether to invest or not invest in a new capital project. It is more correct from a mathematical point of view and a time value of money point of view than either payback period or discounted payback period. It is even more correct than the profitability index and internal rate of return.
What is Net Present Value?
Net present value is one of many capital budgeting methods used to evaluate physical asset investment projects in which a business might want to invest. Usually, these capital investment project are large in terms of scope and money.
Net present value uses discounted cash flows in the analysis which makes net present value the most correct of any of the capital budgeting method as it considers both the risk and time variables. It means that a net present value analysis evaluates the cash flows forecasted to be delivered by a project by discounting them back to the present using 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.
Types of Capital Projects Where You Use Net Present Value
Before you can use net present value to evaluate a capital investment project, you have 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 or not they are independent or mutually exclusive and make your 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, payback period'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 is true for discounted payback period. Those are only two examples.
Net present value also has its own decision rules. Here they are:
Independent projects: If NPV is great than $0, accept the project.
Mutually exclusive projects: If NPV of one project is greater than the NPV of the other project, accept the project with the highest NPV. If both projects have a negative NPV, reject both projects.
Let's say that Firm XYZ, Inc. is considering two projects, Project A and Project B. Project A is a 4-year project with the following cash flows in each of the 4 years: $5,000, $4,000, $3,000, $1,000. Project B is also a 4-year project with the following cash flows in each of the 4 years: $1,000, $3,000, $4,000, $6,750. The firm's cost of capital is 10% for each project, and the initial investment is $10,000. Calculate the NPV for Project A and B and interpret your answer:
We are trying to determine the present value of these cash flows for both projects. Both projects have uneven cash flows. In other words, the cash flows are not annuities. Here is the basic equation for calculating the present value of uneven streams of cash flows:
NPV(p)=CF(0) + CF(1)/(1+i)t + CF(2)/(1+i)t + CF(3)/(1+i)t + CF(4)/(1+i)t
Tip: You can extend this equation for as many time periods as the project lasts.
Interpretation: To calculate NPV, you 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, however, 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.
where i = firm's cost of capital and
where t = the year in which the cash flow is received
Let's calculate the NPV for Project S:
NPV(S)= (-$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 S is $788.20. It means that if the firm invests in the project, it adds $788.20 in value to the firm's worth.
Try an example for yourself. You have the data above for Project L. Use the NPV equation and calculate the NPV for Project L. Go through the steps. You should get $1,004.03. If the two projects are independent, you should accept both since they both have a positive NPV. However, if they are mutually exclusive, you should only accept Project L since it has the highest net present value.
You can see why NPV is a correct capital budgeting decision method since it takes both risk and time into account.