Investors, when deciding on the financing of certain projects, often use special indicators to assess their profitability. Depending on how effective the planned investments will be, the final choice is made and the scope of capital is determined. A popular and quite effective indicator in this matter is net present value (NPV). What does it mean, how is it calculated and what questions does the investor answer? You will learn about it from the article below.
Net present value is also called net present value or present value. In international practice, the use of the abbreviation NPV is adopted, which stands for Net Present Value. It is the sum of all the discounted values of inflows and outflows for the project, given to date. The difference between cash inflows and incurred costs (investments), defined today, is called net present value. Income discounting allows an investor to compare projects that are different in time parameters and make an informed decision on their financing.
What is NPV used for?
The main purpose of this indicator is to give a clear understanding of whether it is worth investing money in one or another investment project. Often, the choice is made between different plans, not only taking into account the length of the life cycle, but also with an eye to the timing of the investment, the size and nature of the income from a particular business. Net present value allows you to “erase” the time frame and bring the expected end result (its value) to one point in time. This makes it possible to see the real effectiveness of investments and the benefits that can be obtained from the implementation of each project. The investor clearly sees the profit, which means that he can confidently give preference to one of the alternative investments - the one with the higher NPT.
Calculation of NPV:
The discounted income is defined as the difference between integral incomes and expenses, reduced to a zero period (today). The formula for calculating the NPV is as follows:
NPV (NPV) = - IC + ƩCFt / (1 + i) t. where t = 1. n.
Consider what all the components of this formula mean:
- IC – initial investment, that is, the planned investments in the project. They are taken with a negative sign, as is the cost of the investor for the implementation of business ideas, which are expected to return in the future. As investments are often carried out not simultaneously, but as needed (distributed in time), then they should also be discounted taking into account the time factor.
- CFt - cash flow discounted over time. It is defined as the sum of all inflows and outflows in each period t (varies from 1 to n, where n is the duration of the investment project).
- i is the discount rate (percent). It is used to discount all expected receipts into a single value of value at the current time.
If NPV \u0026 gt; 0
As already mentioned, the net present value is a standard method for evaluating the effectiveness of a particular investment project. What is the conclusion that can be made if, when calculating the NPV, a value greater than “0” is obtained? This situation suggests that the investment is profitable from an economic point of view. However, the final financing decision can be made only after the NPVs of all the participating projects are determined. Select (ceteris paribus) should be one whose NPV will be greater.
If the NPV
In the event that a negative value was obtained when calculating the net present value of an investment project, the investment will not bring profit. Thus, choosing a project with a NPV \u0026 lt; 0, the investor will not only earn, but also lose some of his money. Here the solution is unequivocal - refusal from financing.
If NPV = 0
It also happens that the discounted income is equal to zero. That is, taking into account the time factor, the investor will not lose anything, but will not earn either. Usually such projects are not taken, with the exception of some cases. For example, if the implementation of a business idea has in addition to a financial other, a more important interest is a social one, for example.
Project profitability based on NPV and PI
Present value is closely associated with such index as the index of profitability (Profitability Index). The latter is an important criterion whether a profitable project to the investor. To determine the sum of the discounted revenues should be divided into the value of all planned expenses: ƩCFt / (1 + i) t / ic. If the profitability index \u0026 gt; 1 (NPV \u0026 gt; 0), then the investment will pay off. If PI \u0026 lt; 1 (NPV \u0026 lt; 0), then the investor will suffer losses. If it is equal to 1, then there will be no result from investments (NPV = 0).
Advantages of calculating the NPV
The advantage of this indicator is the fact that it takes into account the cost of funds in time due to their discounting by one period. In addition, the NPV allows you to include in the calculation the risk of the project. This is achieved through the use of different discount rates - the higher the interest rate, the higher the risk (and vice versa). In general, the NPV indicator can be called a fairly clear criterion for making a decision on financing a business.
The disadvantages of using the indicator include the following: despite the fact that the discounted incomes are included in the calculation (and they often take into account the level of inflation), they are only predictive values and cannot guarantee a certain outcome of events. It is also often difficult to accurately calculate the discount rate, especially if multidisciplinary projects are involved in the assessment.
Example of NPV calculation
Consider an example of how NPV can help a company decide to launch a new product line (planned over three years). Suppose you need to incur the following expenses for the implementation of this event: 2 million rubles at a time (that is, in the period t = 0) and 1 million each year (t = 1-3). It is expected that the annual cash flow will be 2 million rubles (including taxes). The discount rate is 10%. Calculate the net present value of the project:
NPV = -2 / (1 + 0.1) 0 + (2 - 1) / (1 + 0.1) 1 + (2 - 1) / (1 + 0.1) 2 + (2 - 1) / (1 + 0.1) 3 = -2 + 0.9 + 0.83 + 0.75 = 0.48.
Thus, we can see that the implementation of this project will bring the company a profit of $ 480 thousand rubles. The event is truly cost-effective, and the company is better to invest money in this business plan, if other options for capital investment there. However, the amount of profit is not much for the company so that if there are alternative projects should calculate their NPV and compare with data. Only then can you make a final decision.
The indicator of net present value is widely used in both Russian and international practice in determining the effectiveness of investment projects. It gives a fairly clear idea of how profitable investments will be. The undoubted advantage of the NPV indicator is that it determines the change in the value of cash flows over time. This allows you to take into account such factors as the level of inflation, as well as compare projects of different duration and frequency of income. Of course, NPV is not a criterion without flaws. Therefore, along with it, other indicators of efficiency are applied to the evaluation of investment projects. However, this fact does not detract from the merits of the NPV as an important component of making these financial decisions.