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NetPresentValue(NPV)Definition|Calculation|Examples
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NetPresentValue(NPV)
Netpresentvalue(NPV)ofaprojectisthepotentialchangeinaninvestor'swealthcausedbythatprojectwhiletimevalueofmoneyisbeingaccounted
for.Itequalsthepresentvalueofnetcashinflowsgeneratedbyaprojectlesstheinitialinvestmentontheproject.Itisoneofthemostreliable
measuresusedincapitalbudgetingbecauseitaccountsfortimevalueofmoneybyusingdiscountedcashflowsinthecalculation.
Netpresentvaluecalculationstakethefollowingtwoinputs:
Projectednetcashflowsinsuccessiveperiodsfromtheproject.
Atargetrateofreturni.e.thehurdlerate.
Where,
Netcashflowequalstotalcashinflowduringaperiod,includingsalvagevalueifany,lesscashoutflowsfromtheprojectduringtheperiod.
Hurdlerateistherateusedtodiscountthenetcashinflows.Weightedaveragecostofcapital(WACC)isthemostcommonlyusedhurdlerate.
CalculationMethodsandFormulas
ThefirststepinvolvedinthecalculationofNPVistheestimationofnetcashflowsfromtheprojectoveritslife.Thesecondstepistodiscountthose
cashflowsatthehurdlerate.
Thenetcashflowsmaybeeven(i.e.equalcashflowsindifferentperiods)oruneven(i.e.differentcashflowsindifferentperiods).Whentheyareeven,
presentvaluecanbeeasilycalculatedbyusingtheformulaforpresentvalueofannuity.However,iftheyareuneven,weneedtocalculatethepresent
valueofeachindividualnetcashinflowseparately.
Oncewehavethetotalpresentvalueofallprojectcashflows,wesubtracttheinitialinvestmentontheprojectfromthetotalpresentvalueofinflows
toarriveatnetpresentvalue.
ThuswehavethefollowingtwoformulasforthecalculationofNPV:
Whencashinflowsareeven:
NPV=R
1(1+i)n
InitialInvestment
Intheaboveformula,
Risthenetcashinflowexpectedtobereceivedineachperiod
iistherequiredrateofreturnperperiod
narethenumberofperiodsduringwhichtheprojectisexpectedtooperateandgeneratecashinflows.
Whencashinflowsareuneven:
NPV=
R1
(1+i)1
R2
(1+i)2
R3
(1+i)3
+...
InitialInvestment
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NetPresentValue(NPV)Definition|Calculation|Examples
Where,
iisthetargetrateofreturnperperiod
R1isthenetcashinflowduringthefirstperiod
R2isthenetcashinflowduringthesecondperiod
R3isthenetcashinflowduringthethirdperiod,andsoon...
DecisionRule
Incaseofstandaloneprojects,acceptaprojectonlyifitsNPVispositive,rejectitifitsNPVisnegativeandstayindifferentbetweenacceptingor
rejectingifNPViszero.
Incaseofmutuallyexclusiveprojects(i.e.competingprojects),accepttheprojectwithhigherNPV.
Examples
Example1:EvenCashInflows:Calculatethenetpresentvalueofaprojectwhichrequiresaninitialinvestmentof$243,000anditisexpectedto
generateacashinflowof$50,000eachmonthfor12months.Assumethatthesalvagevalueoftheprojectiszero.Thetargetrateofreturnis12%
perannum.
Solution
Wehave,
InitialInvestment=$243,000
NetCashInflowperPeriod=$50,000
NumberofPeriods=12
DiscountRateperPeriod=12%12=1%
NetPresentValue
=$50,000(1(1+1%)^12)1%$243,000
=$50,000(11.01^12)0.01$243,000
$50,000(10.887449)0.01$243,000
$50,0000.1125510.01$243,000
$50,00011.2551$243,000
$562,754$243,000
$319,754
Example2:UnevenCashInflows:Aninitialinvestmentof$8,320thousandonplantandmachineryisexpectedtogeneratecashinflowsof$3,411
thousand,$4,070thousand,$5,824thousandand$2,065thousandattheendoffirst,second,thirdandfourthyearrespectively.Attheendofthe
fourthyear,themachinerywillbesoldfor$900thousand.Calculatethenetpresentvalueoftheinvestmentifthediscountrateis18%.Roundyour
answertonearestthousanddollars.
Solution
PVFactors:
Year1=1(1+18%)^10.8475
Year2=1(1+18%)^20.7182
Year3=1(1+18%)^30.6086
Year4=1(1+18%)^40.5158
Therestofthecalculationissummarizedbelow:
Year
NetCashInflow
$3,411
$4,070
$5,824
$2,065
$3,411
$4,070
$5,824
$2,965
SalvageValue
TotalCashInflow
PresentValueFactor
PresentValueofCashFlows
900
0.8475
0.7182
0.6086
0.5158
$2,890.68
$2,923.01
$3,544.67
$1,529.31
TotalPVofCashInflows
$10,888
InitialInvestment
8,320
NetPresentValue
$2,568 thousand
StrengthsandWeaknessesofNPV
Strengths
Netpresentvalueaccountsfortimevalueofmoneywhichmakesitasounderapproachthanotherinvestmentappraisaltechniqueswhichdonot
discountfuturecashflowssuchpaybackperiodandaccountingrateofreturn.
NetpresentvalueisevenbetterthansomeotherdiscountedcashflowstechniquessuchasIRR.InsituationswhereIRRandNPVgiveconflicting
decisions,NPVdecisionshouldbepreferred.
Weaknesses
NPVisafterallanestimation.Itissensitivetochangesinestimatesforfuturecashflows,salvagevalueandthecostofcapital.
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NetPresentValue(NPV)Definition|Calculation|Examples
Netpresentvaluedoesnottakeintoaccountthesizeoftheproject.Forexample,sayProjectArequiresinitialinvestmentof$4milliontogenerateNPV
of$1millionwhileacompetingProjectBrequires$2millioninvestmenttogenerateanNPVof$0.8million.IfwebaseourdecisiononNPValone,we
willpreferProjectAbecauseithashigherNPV,butProjectBhasgeneratedmoreshareholderswealthperdollarofinitialinvestment($0.8million/$2
millionvs$1million/$4million).
WrittenbyIrfanullahJan
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