Net Present Value Analysis

The Need for Net Present Value Analysis

Many decisions in a business are based on whether there will be a net change in cash flows for the
entity, either in or out. There are many triggers that can cause a cash flow, such as:

The purchase of a fixed asset

The cost of labor to operate a machine

The sale of an asset once its intended purpose has been fulfilled

Cash receipts from the sale of goods produced

Tax payments related to earnings from an acquired asset

These triggers are most commonly associated with the purchase of a fixed asset, such as a production
line.
The trouble with analyzing these cash flows is that they usually occur over multiple years, so there
must be a method for making all of them comparable in the current period, when the decision related
to these cash flows is being made. The solution is to apply a discount rate to each of the future cash
flows that reduces their value in the future to their value on the current date. Once a discount rate has
been applied to all of the incoming and outgoing cash flows, they can be combined into what is known
as the net present value of a decision.
Example of Net Present Value Analysis
It is easiest to explain the net present value concept through an example. The following table
contains the cash flows associated with a decision to purchase a machine, with the net cash flows
listed for each of the next five years. Of particular interest is the discount factor stated in the third
column, which assumes the existence of an 8% interest rate through the five-year period. This
discount rate has an increasing effect on the present value of a cash flow in later years, so that the
discount rate has no effect for cash flows occurring at once, but reduces the present value by about
32% for cash flows occurring in five years. The total net present value of the decision is stated in the
bottom right cell of the table.
Year

Cash Flow

Discount Factor*

Present Value

-$120,000

1.000

-$120,000

+35,000

.9259

+32,407

+35,000

.8573

+30,006

+35,000

.7938

+27,783

+25,000

.7350

+18,375

+25,000

.6806

+17,015
Net Present Value = +$5,586

The reason why the discount rate has a greater impact on cash flows further away in time is that
these cash flows are worth less, since you have to wait longer to receive them.
The Net Present Value Formula
The discount rate is included in present value tables that are readily available in books on accounting
and finance. Discount rates can also be calculated using the following formula:
Present value of

Future cash flow

a future cash flow = ----------------------------------------------------------------------------------(1 + Discount rate) (Squared by the number of periods of discounting)

Using the preceding formula, if there is an expectation of receiving $150,000 in one year, and the
current discount rate is assumed to be 10%, then the calculated net present value of the future cash
receipt is:
$150,000
Present value = -----------------(1 + .10)1
Present value = $136,363.64
Additional Net Present Value Factors
There can be a considerable number of variations on the possible cash flows associated with a
business decision, making the net present value calculation more difficult to derive. The following
factors may also need to be considered:

Throughput on goods sold. If the decision relates to an investment that will result in the sale
of goods, include cash flows from the throughput generated by these goods. Throughput is sales
minus all totally variable expenses.

Cash from sale of asset. If an asset is to be purchased, also assume that some cash will be
received at a later date from the eventual sale of that asset.

Maintenance costs. If there will be incremental costs incurred to maintain a purchased asset,
include the cash flows associated with these costs. Do not include any cash flows related to
maintenance personnel who will still be paid, irrespective of the presence of the asset.

Working capital. If there will be an incremental change in the amount invested in accounts
receivable or inventory as the result of a purchase decision, include these cash flows in the analysis. If
the asset is to be eventually sold off, this may mean that the related working capital investment will
be terminated at the same time.

Tax payments. Include any property taxes related to assets that are acquired. Also, include
the amount of any incremental income taxes paid, if the acquired asset generates profits.

Depreciation effect. Include the effect on income taxes paid of the depreciation expense
associated with an acquired asset. This effect is caused by the tax deductibility of depreciation.
In short, net present value analysis is an effective way to aggregate the cash flows associated with a
business decision that are spread over a number of time periods, though some analysis may be
required to accumulate all of the relevant cash flows.

OR

If you were offered $100 today or $100 a year from now, which would you choose? Would
you rather have $100,000 today or $1,000 a month for the rest of your life?
Net present value (NPV) provides a simple way to answer these types of financial
questions. This calculation compares the money received in the future to an amount of
money received today, while accounting for time and interest. It's based on the principle
of time value of money (TVM), which explains how time affects monetary value. (For
background reading, see Understanding The Time Value Of Money.)
The TVM calculation may look complicated, but with some understanding of NPV and how
the calculation works, along with its basic variations: present value and future value, we can
start putting this formula to use in common application.
Tutorial: Fundamental Analysis

Time Value of Money

If you were offered $100 today or $100 a year from now, which would be the better option
and why?
This question is the classic method in which the TVM concept is taught in virtually every
business school in America. The majority of people asked this question choose to take the
money today. But why? What are the advantages and, more importantly, disadvantages of
this decision?
There are three basic reasons to support the TVM theory. First, a dollar can be invested and
earn interest over time, giving it potential earning power. Also, money is subject to inflation,
eating away at the spending power of the currency over time, making it worth less in the
future. Finally, there is always the risk of not actually receiving the dollar in the future - if you
hold the dollar now, there is no risk of this happening. Getting an accurate estimate of this
last risk isn't easy and, therefore, it's harder to use in a precise manner.
Illustrating the Net Present Value
Would you rather have $100,000 today or $1,000 a month for the rest of your life?
Most people have some vague idea of which they'd take, but a net present value calculation
can tell you precisely which is better, from a financial standpoint, assuming you know how
long you will live and what rate of interest you'd earn if you took the $100,000.
Specific variations of time value of money calculations are:

Net Present Value (lets you value a stream of future payments into one lump sum
today, as you see in many lottery payouts)

Present Value (tells you the current worth of a future sum of money)

Future Value (gives you the future value of cash that you have now)

Determining the Time Value of Your Money

Which would you prefer: $100,000 today or $120,000 a year from now?
The $100,000 is the "present value" and the $120,000 is the "future value" of your money. In
this case, if the interest rate used in the calculation is 20%, there is no difference between
the two.

Five Factors of a TVM Calculation.

1.Number of time periods involved (months, years)
2.Annual interest rate (or discount rate, depending on the calculation)
3.Present value (what do you have right now in your pocket)
4.Payments (if any exist. If not, payments equal zero)
5.Future value (the dollar amount you will receive in the future. A standard mortgage will
have a zero future value, because it is paid off at the end of the term)
Many people use financial calculators to quickly solve these TVM questions. By knowing
how to use one, you could easily calculate a present sum of money into a future one, or vice
versa. The same goes for determining the payment on a mortgage, or how much interest is
being charged on that short-term Christmas expenses loan. With four of the five
components in-hand, the financial calculator can easily determine the missing factor. To
calculate this by hand, the formulas for future value (FV) and present value (PV) would look
like this:
FV = PV (1+i)N
PV = FV
(1+i)N
Applying Net Present Value Calculations
Net present value calculations can also help you discover answers to other
questions. Retirement planning needs can be determined on an overall, monthly or annual
basis, as can the amount to contribute for college funds. By using a net present value
calculation, you can find out how much you need to invest each month to achieve your goal.
For example, in order to save $1 million dollars to retire in 20 years, assuming an annual
return of 12.2%, you must save $984 per month. Try the calculation and test it for yourself.
(To learn more about how compounding contributes to retirement savings, see Young
Investors: What Are You Waiting For? and Why is retirement easier to afford if you start
early?)
Below is a list of the most common areas in which people use net present value calculations
to help them make decisions and solve their financial problems.

Mortgage payments

Student loans

Savings

Home, auto or other major purchases

Credit cards

Money management

Retirement planning

Investments

Financial planning (both business and personal)

The Bottom Line on Net Present Value

The net present value calculation and its variations are quick and easy ways to measure the
effects of time and interest on a given sum of money, whether it is received now or in the
future. The calculation is perfect for short- and- long-term planning, budgeting or reference.
When plotting out your financial future, keep this formula in mind.

Read more: Time Value Of Money: Determining Your Future

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PRESENT VALUE CONCEPT:

The present value (PV) of an amount to be received in the future is the discounted face
value considering the length of time the receipt is deferred and the required rate of
return (or appropriate discount rate under the circumstances). The notion of present
value presumes that money has a time valuetoday 1 ;s dollar is worth more than the
same dollar received at a future point in timederiving from inflation, interest, and other
considerations. This idea is used commonly when planning a capital budget.
This notion can be demonstrated by examining three common financial transactions:

Money invested in bank certificates of deposit may earn interest at 5 percent. At that
rate, $1,000 deposited on January 1 will accumulate $50 of interest by December 31,
making the total available to the investor $1,050. Since this investor is willing to lend his
money to the bank for 5 percent annual interest, that rate may be viewed as the required
rate of return, or the discount rate. The $1,050 to be received on December 31 had a PV
to that investor at January I of exactly $1,000 (1,050/(1 +.05)').

Annuity contracts can be bought from insurance companies whereby a single payment is
made to the insurance company in exchange for a defined series of annual (or monthly)
payments made back to the buyer. In these cases the simple sum of the periodic
repayments from the insurance company to the buyer exceed the original annuity
purchase price, in absolute terms. However, when considering the deferred repayment
and the implied rate of return on the money loaned, the amounts exactly equate, on a
present value basis.

Mortgage loans are basically the reverse of the above described annuity contract. Here,
the individual borrows the money, promising to make scheduled repayments to the
lender. Again, due to the differential timing of cash flows, and the fact that the bank
requires interest to be paid on the borrowed funds, the PVs equate. That is, the PV of the
sum of the future mortgage payments is exactly equal to the amount borrowed (which by
definition is at the PV on the date of the loan).

CALCULATING PRESENT VALUE

The formula for calculating the present value of a series of future receipts is:
where CF 1 to CF n = future receipts
i = the interest or discount rate appropriate for the stated period
n = the number of periods over which future receipts occur

RATE OF RETURN.
The interest or discount rate used in PV calculations is a key element in determining the
PV. This importance is emphasized when the future amounts occur over an extended
period of time, due to the power of compounding. For example, the final payment on a
30-year loan at 7 percent interest would be worth approximately 13.1 percent of its face
amount on a present value basis at the date of loan origin [1/(1 + .07) 30 ]. By contrast,

the 30th payment on a loan with a 9 percent interest rate would be worth only 7.5
percent [1/(1 + .09) 30 ] of its face amount in present value terms at the origin. This simple
example shows the power of compounding when time periods are long.
The discount rate used in a given circumstance must provide for compensation to the
lender of funds for three elements of return:
1. Inflation: just to keep even in terms of buying power, the return of money at a future date
must be appended by the rate of general price inflation as measured by the Consumer
Price Index (CPI). In other words, if a person lends an amount of money adequate to buy
a loaf of bread at time t=0, he will require repayment at t = I of the original amount plus
the fraction of that amount representing the CPI increase over the period. That way he
will be able to buy the same loaf of bread at t = 1.
2. Time value of money (TVM): beyond simply keeping even with inflation, the investor or
lender has a basic preference for consumption sooner rather than later. The cost of
compensating for this aspect of human nature has been found to be about 1 to 2 percent
per year. That is, the real rate of return on risk-free assets has averaged about 1.5
percent.
3. Risk: in addition to postponing the preferred immediate consumption and having to
reimburse for inflation's erosion of buying power, many types of investment involve a risk
of default. That is, the investor may never again see his funds, for example if the
company goes bankrupt. Compensating for this element of required return can be
considerably more expensive than the first two combined. For example, junk bonds may
be paying interest at 12 percent, while anticipated inflation is only 4 percent and TVM is
about 1.5 percent. This would mean that the risk premium component of the overall
interest rate is 6.5 percent (12 percent4 percent1.5 percent).

NET PRESENT VALUE

An important extension of present value is net present value (NPV), which is simply the
sum of present values for an investment's anticipated returns over time offset by its upfront costs. This is an important decision-making tool because an investment may
appear lucrative in today's money, but once its returns are discounted it may reveal the
investment would yield a net loss for the company compared to other options.

Imagine a company that has an opportunity to invest in a five-year joint venture with
another firm beginning in 2002. The company would have to put up $100,000 at the
start to fund its share, but the annual returns to the company are expected be $30,000 a
year for five years. On the surface, it appears that the company would reap a 50 percent
return on its investment, since $30,000 5 = $150,000.
Net present value paints a different scenario, however. Recall from the time value of
money theory that $50,000 in five years is worth less than the same nominal figure
today. There are also opportunity costs and capital acquisition costs to consider. What is
the company losing by not using the $100,000 elsewhere? and how much does it cost
the company to obtain new capital?
The latter question forms the basis for determining a minimum required rate of return on
such an investment; if the returns on capital don't at least match the costs of obtaining it,
the investment is losing money.

Table 1
Using Present Value to Evaluate
Investment Returns

The expected returns on the hypothetical investment below indicate a poor investment because
the net present value at the end of the period is negative.
Year

Nominal Return

Present Value at Year End

2002

30,000

25,863

2003

30,000

22,296

2004

30,000

19,221

2005

30,000

16,569

The expected returns on the hypothetical investment below indicate a poor investment because
the net present value at the end of the period is negative.
Year

Nominal Return

Present Value at Year End

2006

30,000

14,283

Gross return

150,000

98,232

Minus cost

(100,000)

Net present value

(1,768)

With that in mind, suppose the company determines that its minimum rate of return is 16
percent given current interest rates, inflation, the risks associated with the investment,
and so forth. Table I shows how the net present value of the venture would be
computed. As the figures indicate, once the annual returns are discounted based on the
company's capital costs and other factors, their present values as of 2002 would yield a
negative NPV, a signal to management that the venture is probably not worthwhile. Not
only would management expect a positive NPV, but if it has several options it would
likely choose the one with the highest positive NPV.
SEE ALSO : Discounted Cash Flow

FURTHER READING:
Birrer, G. Eddy, and Jean L. Carrica. Present Value Applications for Accountants and
Financial Planners. Westport, CT: Quorum Books, 1990.
Robison, Lindon J., and Pete J. Barry. Present Value Models and Investment
Analysis. East Lansing, MI: Michigan State University Press, 1998.

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