NET PRESENT VALUE

Net present value method determines the cash inflows and outflows at the same time
period. Since cash inflows are to be received in the future while cash outflows (e.g. cost of
investment) are made at the start of the project, there is apparent inconsistency in the timing of
cash flows. The solution is to discount the future cash inflows to their present values before
comparing to the cost of investment.
Illustrative Example: If offered an investment of P7,000 today and promises to pay you P9,000
two years from today and if your opportunity cost for projects of similar risk is 10%, would
you make this investment?
First step would be to determine the value of the cash inflow of P9,000 two years earlier.
This process of getting the present value of the future cash flow is also known as discounting.
To discount, multiply the future inflow /outflow by its Present Value factor (PVF) which varies
according to its timing and regularity of receipt. Consider the following table:
Case

Name or Designation

If the cash flow occurs ones

PV of 1

If the cash flow occurs at regularly &

equally &:
a. made at the end of the period
b. made at the beginning of the period

Formula
n

(1+i)

PV of an ordinary annuity of
1
PV of annuity due of 1

1(1+i )
i

1(1+i)(n1)
+1
i

whereby: n=no. of periods; i=interest rate divided by the no. of times occurred in a year.
In the preceding example, PVF approximate to 0.8264 [(1+ .10) -2].The present value of
the cash inflow would then be P7, 348 today. This value would be compared to the present
value of the cash outflow. Since it is made today, then the time lapsed would be zero. Simply
stated, there is no need to discount the cash outflow. By investing P7, 000 cash today,
therefore, you are getting in return, a promise of cash flow in the future that is worth an increase
in your wealth by P438 when you make this investment.
To reiterate, Net Present Value (NPV) is the excess of the present value of cash inflows
generated by the project over the amount of the initial investment. This method considers the
time value of money. It tells a company how much a project contributes to shareholder wealth
the larger the NPV, the more value the project adds; and added value means a higher stock
price. Basically, the formula of NPV is:
Present Value of Cash Inflows (PVCI)
Less: Cost of Cash Outflow (CCO)
Net Present Value

P xxx
(xxx)
P xxx

where: PVCI= Annual Cash Inflow (ACI) x PVF

If the cash inflows are uniform or even, the above formula may be used. However, if the
cash inflows are not uniform or uneven, no short cut method is to be used. Instead, you may
use this formula:

PVCI=( ACI x PVF )

Under this formula, cash inflows are unequal and there is regularity. The present value of
each inflow at different time periods is computed. Furthermore, the summation of all present
values is get.
Using this method of screening projects, the decision criterion would be:
If the Net Present Value is
Positive

Decision
Accept it because its return is greater than the
required rate of return.
Be Indifferent because its return is equal to the
required rate of return.

Zero
Negative

Reject it outright because its return is less than the

required rate of return.

Sample Problem (even cash inflow): ABS Company is planning to invest in an equipment, The
equipment costs P800,000. If it will be used in the operations, it will generate annual net
cash inflows of P250,000. At the end of its useful life of five years, the equipment will have a
P20,000 residual value. Additional working capital of P200,000 is needed. The desired rate
of return is 14%. Should the investment be approved?
Solution:
Net
Inflow

Cash PVF@
14%

PVCI

PVCI:
Regular

250,000

3.433

858,250

Residual

20,000

0.519

10,380

Add'l WC

200,000

0.519

103,800

Total PVCI
Less:
Cost
Investment

972,430
of
Equipment
Add'l WC

Net Present Value

800,000
200,000

1,000,000
(27,570)

The residual value is considered as a future cash inflow as evidence by the proceeds if it
will be sold when seemed to be useless. Moreover, the additional working capital required
serves as an inflow and an outflow of cash. As per its state of being highly liquid, working capital
would be converted from cash to other assets (suggesting a cash outflow) and from non-cash
assets back to cash (signifying a cash outflow).

Decision:
Since NPV is negative, REJECT the investment plan.

Sample Problem (uneven cash inflow): An equipment costing P680, 000, with a residual value
of P8,000 at its
useful life of five
1st year
P 350,000
years, is expected
to bring the following
nd
2
year
P
250,000
net
of
cash
inflows:
3rd year
P 150,000
4th year
P 100,000
5th year
P 50,000

Determine the net present value using a discounted rate of 12 %.

Solution:
Net Cash
Inflows

PVF @
12 %

PV of Cash
Inflows

Year 1

350,000

0.893

312,550

Year 2

250,000

0.797

199,250

Year 3

150,000

0.712

106,800

Year 4

100,000

0.636

63,600

Year 5

50,000

0.567

28,350

Residual Value
Total PVCI
Less: Cost of
Investment
Net Present Value

8,000

0.567

4,536
715,086
680,000
35,086

Decision: Since the project has a positive net present value, it is acceptable.
The Use of Indexes
The ranking of acceptable projects is done when there is a constraint on resources such
as money, manpower and materials. The process of allocating available money to the most
prioritized investment proposals is known as capital rationing. Indexes are normally used to

rank projects that are acceptable. In the ranking process, the project that has the highest index
has the highest priority. Two indexes are derived from the computation of NPV profitability
index and NPV index.

PROFITABILITY INDEX
This index indicates the profitability of a certain project. It is computed as follows:

Profitability Index(PI )=

Present Value of Cash Inflows(PVCI )

Cost of Cash Outflow (CCO)

NPV INDEX
To some practitioners, the desirability index using the net present value instead of the
total present values of cash inflows as the numerator is more preferred. It is because it
obviously shows that a certain alternative would not be considered in the ranking. The purpose
of profitability index is to provide a basis for comparison between or among projects of different
sizes. The index expresses the present value of cash benefits as to an amount per peso of
investment in a project. The formula is:

Net Present Value Index(NPVI)=

Cost of Cash Outflow(CCO)

Present Value of Cash Inflows( PVCI )

The decision criterion would be:

If the
Profitability Index 1
Profitability Index 1

Then the project is

Acceptable
Rejected

Sample Problem: Consider the following project proposals of:

Project
5,500,000P 500,000
7,200,000
4,850,000
3,470,000

CCO

1,200,000
850,000
470,000

PVCI

NPV
A
B

P 5,000,000 P
6,000,000
C
4,000,000
D
3,000,000

Which projects should the company invest if his budget is P 12,000,000?

Solutions/Discussions:
The indexes, project rating and the project investments are determined as follows:

Project

CCO

PVCI

NPV

Profitabilit
y
Index

NPV
Index

Rank

Investme
nt shall
be made
to

P5,000,000

P500,000

1.10

0.10

6,000,000

P5,500,00
0
7,200,000

1.20

0.20

C
D

4,000,000
3,000,000

4,850,000
3,470,000

1,200,00
0
850,000
470,000

1.21
1.16

0.21
0.16

1
3

The project with the highest priority is project C, because it has the highest profitability
index and NPV index.
The business shall invest its money to projects C and B having ranks 1 and 2,
respectively. The total investment for projects C and B is P 10 million (P 6 million + P 4 million).
Since the company has only P 12 million, it has only remaining P 2 million which is already
insufficient for the investment to finance project D (the 4 th priority) that needs P5 million
investment.
There are times where the remaining fund balance for the investment is inadequate for
the next (e.g. project D) project proposal but is enough for the succeeding project proposals
(e.g. project A) and the company wishes to maximize funds for investment. In this case, the
succeeding rank projects will receive the allocation for the investment.
Comparing Projects with Unequal Lives
NPV and IRR can sometimes lead to conflicting results in the analysis of mutually
exclusive projects. One reason for this potential problem is the timing of the cash flows of the
mutually exclusive projects. As a result, we need to adjust for the timing issue in order to correct
this problem. One way to do such is to do the replacement-chain method.
REPLACEMENT-CHAIN METHOD
A replacement chain is a method of comparing mutually exclusive projects that have
unequal lives. Each project is replicated such that they will both terminate in a common year. If
projects with lives of 3 years and 5 years are being evaluated, the 3- year project would be
replicated 5 times and the 5-year project replicated 3 times; thus, both projects would terminate
in 15 years.
Not all projects maximize their NPV if operated over their engineering lives and therefore
it may be best to terminate a project prior to its potential life. The economic life is the number of
years a project should be operated to maximize its NPV, and is often less than the maximum
potential life. Capital rationing occurs when management places a constraint on the size of the
firms capital budget during a particular period.

Illustrative Example: Buco is planning to add new machinery to its current plant. There are two
machines Buco is considering, with cash flows as follows:
Figure 1: Discounted cash flows for Machine A and Machine B

Compare the two projects with unequal lives using the replacement-chain method.
In this example, Machine A has an operating lifespan of six years. Machine B has an
operating lifespan of three years. The cash flows for each project are discounted by Newco's
calculated WACC of 8.4%.

NPV of Machine A is equal to P2,926.

NPV of Machine B is equal to P1,735.

The initial analysis indicates that Machine A, with the greater NPV, should be the project
chosen.

The IRR of Machine A is equal to 8.3%.

The IRR of Machine B is equal to 15.5%.

This analysis indicates that Machine B, with the greater IRR, should be the project
chosen.
The NPV analysis and the IRR analysis have given us differing results. This is most
likely due to the unequal lives of the two projects. As such, we need to analyze the two projects
over a common life.
For Machine A (project 1), the lifespan is six years. For Machine B (project 2), the
lifespan is three years. Given that the lifespan of the longest project is six years, in order to
measure both over a common life, we must adjust the lifespan of Machine B to six years.
Because the lifespan of Machine B is three years, the lifespan of this project needs to be
doubled to equal the six-year lifespan of Machine A. This indicates that another Machine B
would have to be purchased (to get two machines with a lifespan of three years each) to get to
the six-year lifespan of Machine A - hence, the replacement-chain method.
The new cash flows would be as follows:

Figure

11.9:

Cash

flows

over

NPV of Machine A remains P2,926.

NPV of Machine B is now P3,098 given the adjustment.

common

life

The initial analysis indicates that Machine B, with the greater NPV, should be the project
chosen. Recall, this is different from our first analysis where Machine A was chosen given its
greater NPV.

The IRR of Machine A remains 8.3%.

The IRR of Machine B remains 15.5%.

Note: while the NPV has changed given the additional cash flows, the IRR for the
projects
remain
the
same.
This analysis indicates that Machine B, with the greater IRR, should be the project chosen.
Recall, this is the same as our first analysis, where Machine B was chosen given its greater
IRR.
With the cash flows adjusted with the replacement-chain method, both the NPV and the IRR
arrive at the same conclusion. With this adjusted analysis, MACHINE B (project 2), should be
the
project
ACCEPTED.