Net Present Value (NPV): Present value of cash flows minus initial investments, The Net Present Value (NPV) method as an investment appraisal or capital budgeting technique shows how an investment project affects company shareholders’ wealth in present value terms. Maximizing shareholders’ wealth is an important goal for management, and investment projects with positive NPV are wealth enhancing and should be accepted.
Net Present Value
Net Present Value (NPV) : The difference between the present value of cash inflows and the present value of cash outflows.
When we analyze whether to invest in a particular project or not, or to choose between two or more projects, the most simple & commonly used test is to calculate the NPV. Unlike some techniques where time value of money is not given due importance, NPV is calculated by keeping into mind the concept of time value of money, that is, the effect of inflation & other factors is also considered here.
Now the question is:
How do we calculate the Net Present Value?
To calculate the NPV, we should predict the future cash in flows, ascertain the future cash out flows & determine a rate at which discounting is to be done (to calculate the time value of money). Let us do this with the help of an example:
Eg. ABC Ltd. is planning to invest in one of these two projects. Project – A involving Initial Cash Out flow of Rs. 10 Lacs, estimated cash in flow is say, Rs. 4 Lacs per annum for the next 4 years. Project B involving initial Cash Out flow of Rs. 12 Lacs, estimated cash in flows is say, Rs. 5 lacs per annum for the next 4 years. The rate of discounting to be considered is 15%.
Solution:
| Particulars | Project – A | Project – B |
| [A] Cash In flow | Rs. 4 Lacs | Rs. 5 Lacs |
| [B] PVAF @ 15% for 4 years | 2.8550 | 2.8550 |
| [C] Present Value of Cash In flows { A * B } | Rs. 11.42 Lacs | Rs. 14.28 Lacs |
| [D] Initial Cash Out flow | Rs. 10 Lacs | Rs. 12 Lacs |
| [E] Net Present Value { C – D } | Rs. 1.42 Lacs | Rs. 2.28 Lacs |
As seen above, the Net Present value for both the projects is positive. So, if we have an option to choose multiple projects, we can opt for both of them. However, if we had a negative NPV for either of these projects, we would have rejected the same.
In the above case, we had to choose only one of the above-mentioned projects. So, we will choose the project which offers the maximum NPV & also suits our investment aspects. So, if the management of the company so agrees, choosing Project B over Project A is more beneficial to the company.
Now you must be wondering what should the company do when the NPV comes to be 0, well, when the Net Present Value is 0, it is upon the management of the company to decide whether to accept or reject the project. However, it is generally seen that in such cases, the project is accepted by the management. This is so because the rate of discounting is an approximate guess of the management & is generally a little higher as compared to the actual scenario.
Thus, NPV is a good technique to ascertain whether a project is acceptable or not. There are some other techniques as well about which you will get to know in my following articles.
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