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Net present value is the present value of net cash inflows generated by a project including salvage value, if any, less the initial investment on the project. It is one of the most reliable measures used in capital budgeting because it accounts fortime value of money by using discounted cash inflows. Before calculating NPV, a target rate of return is set which is used to discount the net cash inflows from a project. Net cash inflow equals total cash inflow during a period less the expenses directly incurred on generating the cash inflow.
NPV = R
In the above formula, R is the net cash inflow expected to be received each period; i is the required rate of return per period; n are the number of periods during which the project is expected to operate and generate cash inflows. When cash inflows are uneven:
NPV =
Where,
i is the target rate of return per period; R1 is the net cash inflow during the first period; R2 is the net cash inflow during the second period; R3 is the net cash inflow during the third period, and so on ...
Decision Rule
Accept the project only if its NPV is positive or zero. Reject the project having negative NPV. While comparing two or more exclusive projects having positive NPVs, accept the one with highest NPV.
Examples
Example 1: Even Cash Inflows: Calculate the net present value of a project which requires an initial investment of $243,000 and it is expected to generate a cash inflow of $50,000 each month for 12 months. Assume that the salvage value of the project is zero. The target rate of return is 12% per annum. Solution We have, Initial Investment = $243,000 Net Cash Inflow per Period = $50,000 Number of Periods = 12 Discount Rate per Period = 12% 12 = 1% Net Present Value = $50,000 (1 (1 + 1%)^-12) 1% $243,000 = $50,000 (1 1.01^-12) 0.01 $243,000 $50,000 (1 0.887449) 0.01 $243,000 $50,000 0.112551 0.01 $243,000 $50,000 11.2551 $243,000 $562,754 $243,000 $319,754 Example 2: Uneven Cash Inflows: An initial investment on plant and machinery of $8,320 thousand is expected to generate cash inflows of $3,411 thousand, $4,070 thousand, $5,824 thousand and $2,065 thousand at the end of first, second, third and fourth year respectively. At the end of the fourth year, the machinery will be sold for $900 thousand. Calculate the present value of the investment if the discount rate is 18%. Round your answer to nearest thousand dollars. Solution PV Factors: Year 1 = 1 (1 + 18%)^1 0.8475 Year 2 = 1 (1 + 18%)^2 0.7182 Year 3 = 1 (1 + 18%)^3 0.6086 Year 4 = 1 (1 + 18%)^4 0.5158 The rest of the problem can be solved more efficiently in table format as show below: Year Net Cash Inflow Salvage Value Total Cash Inflow Present Value Factor Present Value of Cash Flows Total PV of Cash Inflows Initial Investment Net Present Value $3,411 0.8475 $10,888 8,320 $2,568 thousand $4,070 0.7182 $5,824 0.6086 1 $3,411 2 $4,070 3 $5,824 4 $2,065 900 $2,965 0.5158