Report on

NET PRESENT VALUE

Prepared by: Raheel Ahmed Siddiqui FA11-MB-0113 Hafiz Muhammad Arsalan Omair Maqbool Submitted to: Mr. Baber Saleem Date: 29th Nov 2012

Net Present Value

Net Present Value defined:
The difference between the present value of the future cash flows from an investment and the amount of investment NPV can be described as the difference amount between the sums of discounted: cash inflows and cash outflows. It compares the present value of money today to the present value of money in future, taking inflation and returns into account The NPV of an investment proposal is the present value of the proposals net cash flows less the proposals initial cash flows Present value of the expected cash flows is computed by discounting them at the required rate of return.

What is Net Present Value:

NPV is the difference between the present value (PV) of all future cash flows produced by a rental property and the amount of cash investment (or, initial investment; down payment and closing costs) required to purchase the property. Example: Let's assume that the investor desires a 10% yield on all future cash flows, must invest $100,000 cash to purchase those cash flows, and wants to know whether the price he or she will pay achieves the desired yield. NPV would be calculated in the following manner: 1. Discount back all future cash flows at 10% (the desired rate of return) to determine the present value (PV) of those future cash flows. 2. Deduct the investment (or initial investment) of $100,000 from the present value (PV) of those future cash flows.

How NPV Works?

NPV will always appear as an amount in one of three ways: greater than zero, zero, or less than zero. We have two examples below that illustrate an amount that is greater than zero and less than zero to give you the idea. EXAMPLE A: Let's assume that the PV of all future cash flows is $110,000. We would calculate NPV by subtracting $100,000 (the initial investment) from $110,000 (the PV of all future cash flows). NPV = $110,000 - 100,000 = $10,000 EXAMPLE B: Let's assume that the PV of all future cash flows is $90,000. We would calculate NPV by subtracting $100,000 (the initial investment) from $90,000 (the PV of all future cash flows). NPV = $90,000 - 100,000 = -$10,000

What it means?
When NPV is greater than zero it means that the discounted value of future cash flows is greater than your initial investment and you would be getting an even higher return than you desire. When NPV is zero it means that the discounted value of future cash flows equals your initial investment and you would be getting exactly the return you desire. When NPV is less than zero (a negative number) it means that the discounted value of future cash flows is less than your initial investment and you would be getting a lower return than you desire. Lets interpret our two examples. EXAMPLE A: With an NPV of $10,000 (greater than zero) you would be getting a good deal for the property based on your desired yield because you have exceeded it.

EXAMPLE B: With an NPV of -$10,000 (less than zero) you would be paying too much for the property based on your desired yield. You must either buy the property for less or lower your yield if you want to pursue this property.

Formula:

Where, t= the time of the cash flow i= the discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.); the opportunity cost of capital - The net cash flow (the amount of cash, inflow minus outflow) at time t.

Common questions related to NPV:

What is NPV good for? Understanding the future value of money in todays terms. When does a project manager use NPV? In presenting the cost-benefit analysis, or justification for a project. What project documents would you find NPV calculations in? Business cases, project plans, and project portfolio reports. How does NPV help in decision making? It helps compare the value of different projects against investment targets. What impact does (would) NPV have on your project? Reflect on your projects costs and forecast benefits.

The discount rate:

The rate used to discount future cash flows to the present value is a key variable of this process. An NPV calculated using variable discount rates (if they are known for the duration of the investment) better reflects the situation than one calculated from a constant discount rate for the entire investment duration

Use in decision making:

NPV is an indicator of how much value an investment or project adds to the firm. With a particular project, if is a positive value, the project is in the status of positive cash inflow in the time of t. If is a negative value, the project is in the status of discounted cash outflow in the time of it. Appropriately risked projects with a positive NPV could be accepted. This does not necessarily mean that they should be undertaken since NPV at the cost of capital may not account for opportunity cost, i.e., comparison with other available investments. In financial theory, if there is a choice between two mutually exclusive alternatives, the one yielding the higher NPV should be selected. If NPV 0 NV 0 It means The investment would add value to the firm The investment would subtract value from the firm The investment would neither gain or lose value for the firm Then The project may be accepted The project should be rejected We should be indifferent in the decision whether to accept or reject the project. This project adds no monetary value. Decision should be based on other criteria, e.g., strategic positioning or other factors not explicitly included in the

NPV = 0

calculation.

NPV Profile: A graph showing the relationship between a projects net present
value and the discount rate employed In general, the net present value and internal rate of return methods lead to the same acceptance or rejection decision. The graph, called an NPV profile, shows the curvilinear relationship between the net present value for a project and the discount rate employed. When the discount rate is zero, net present value is simply the total cash inflows less the total cash outflows of the project. By definition, the discount rate at that point (the point where the NPV curve intersects the horizontal axis on the graph) represents the internal rate of return the discount rate at which the projects net present value equals zero. For discount rates greater than the internal rate of return, the net present value of the project is negative. If the required rate of return is less than the internal rate of return, we would accept the project.