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 discounted income (BHD). What does it mean, how is it calculated and what questions does the investor answer? You will learn about this from the following article.
The notion of NPE
Net present value is otherwise called net present value or current value. In international practice, the abbreviation NPV is used, which stands for Net Present Value. It is the sum of all the discounted values of the inflows and outflows of the project, cited to date. The difference between cash receipts and incurred costs (investments), determined to date, is called net present value. The discounting of the income allows the investor to compare various on time parameters of projects and to make the weighed decision on their financing.
What is the use of BHD?
The main purpose of this indicator is to give a clear understanding of whether it is worth investing in an 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 on investment terms, the magnitude and nature of incoming revenues from a particular business. Net discounted income allows you to "wipe out" the time frame and bring the expected final result (its value) to one point in time. This gives an opportunity 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 NPM.
Calculation of NPV:
Discounted income is defined as the difference between integral incomes and expenditures, reduced to the zero period (today's date). The formula for calculating the BHD is as follows:
NPV = - IC + ΣCFt / (1 + i) t. where t = 1. n.
Let's consider what all components of the given 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 for the 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 revenues into a single value of the value at the current time.
If the BHP \u0026 gt; 0
As already mentioned, net present income is the standard method of assessing the effectiveness of a particular investment project. What conclusion can be drawn if the value is greater than "0" when calculating the BHD? This situation indicates that from an economic point of view, the investment is profitable. However, the final decision on funding can be made only after the NPV of all participating projects is determined. Choose (with other things being equal) the one with the higher NPC.
If the NPV
In the event that a negative value was obtained in calculating the net present value of the investment project, the investments will not bring profit. Thus, selecting the project with the BHD \u0026 lt; 0, the investor will not only not earn, but lose some of his money. Here the solution is unambiguous - refusal of financing.
If the BHD = 0
It happens that the discounted income turns out to be zero. That is, taking into account the time factor, the investor will not lose anything, but it will not work either. Usually, such projects are not taken, except in some cases. For example, if the implementation of a business idea has, in addition to a financial one, a more important interest - social, for example.
Profitability of the project 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 return index \u0026 gt; 1 (NPV \u0026 gt; 0), then the investments will pay off. If PI \u0026 lt; 1 (NPV \u0026 lt; 0), then the investor will suffer losses. If it is 1, then there will be no result from the investment (NPV = 0).
Pluses for calculating the PDR
The advantage of this indicator is the fact that it takes into account the cost of funds over time due to their discounting to one period. In addition, the BHP allows the risk of project implementation to be included in the calculation. 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.
Disadvantages of the PDR
The disadvantages of using the indicator include the following: in spite of the fact that discounted incomes are included in the calculation (and often they take into account the level of inflation), they are only forecast values and can not guarantee a certain outcome of events. It is also often difficult to accurately calculate the discount rate, especially if multi-profile projects participate in the assessment.
Example of calculating the PDR
Let's consider an example of how NPV can help a company decide on launching a new product line (in a systematic way over three years). Suppose, for the implementation of this event, the following expenses will be incurred: 2 million rubles at a time (i.e., in the period t = 0) and 1 million every year (t = 1-3). It is expected that the annual inflow of cash will be 2 million rubles (including taxes). The discount rate is 10%. We 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 both in Russian and international practice in determining the effectiveness of investment projects. He gives a fairly clear idea of how profitable will be the investment of funds. The undoubted advantage of the BHD is that it determines the change in the value of cash flows over time. This allows you to take into account factors such as the level of inflation, as well as compare the different in terms of duration and periodicity of income projects. Of course, NPV is not a criterion without shortcomings. Therefore, along with it, other performance indicators are applied to the evaluation of investment projects. However, this fact does not detract from the merit of the BHD as an important component of the adoption of these financial decisions.