Denise Elizabeth P
Senior Financial Editor & Contributor

Date Published: August 4, 2022

Net Present Value (NPV) is a capital budgeting technique used to measure the Present Value of future cash inflows and cash outflows and determine whether a new investment or project is feasible.

To determine the net present value of all cash flows, the time value of money is considered.

In using the time value of money, a discounted rate must be used which is called the required rate of return.

Or simply, the NPV is equal to the present value of all cash inflows less the current value of all cash outflows.

When the NPV is a positive amount, it means that the returns outweigh the cost of the investment.

• It considers the time value of money.

• The calculation of the required rate of return does not have set guidelines.
• Projects may be incomparable because of different investment terms and sizes.
• Hidden costs are not considered.

### Considers the Time Value of Money

It is important to consider the power of the time value of money because it will give you a more accurate calculation of the net cash flows of an investment.

The idea behind the time value of money is that the earning capacity of money results in its increasing value – its value today will not be the same tomorrow.

#### Example

A company wishes to invest \$70,000 on a project of another company.

To decide whether the decision in investing on the said project will be beneficial for the investing company, an NPV needs to be calculated.

Required Rate of Return: 12%

Project A

Year 1 – \$8,000

Year 2 – \$14,000

Year 3 – \$ 19,500

Year 4 – \$33,000

Project B

Year 1 – \$12,500

Year 2 – \$14,600

Year 3 – \$18,600

Year 4- 21,000

If time value is not considered, the NPV can be computed as follows:

 Year Project A Project B 1 \$8,000.00 \$12,500.00 2 \$14,000.00 \$14,600.00 3 \$19,500.00 \$18,600.00 4 \$33,000.00 \$21,000.00 Total Cash Inflows (A) \$74,500.00 \$66,700.00 Initial Investment (B) \$50,000.00 \$50,000.00 Net Cash inflow (A-B) \$24,500.00 \$16,700.00

When the two projects are compared, the better choice is to invest in project A.

The invested capital will earn \$24,500.

Using the same example, if the time value of money is considered, the cash inflows can be computed as follows:

 Year Project A Project B 1 \$7,143.00 \$11,161.00 2 \$11,161.00 \$11,639.00 3 \$13,880.00 \$13,239.00 4 \$20,972.00 \$11,820.00 Total Cash Inflows (A) \$53,156.00 \$47,859.00 Initial Investment (B) \$50,000.00 \$50,000.00 Net Cash inflow (A-B) \$3,156.00 -\$2,141.00

The time value of money considered, project A is still more profitable than project B.

However, if the NPV of both projects is computed considering the time value of money, there is a considerable difference in the net cash inflow of both projects.

This is the reason why it is important to always consider the time value of money because it will give a more accurate computation of profit.

### Decision-Making

Computing for the NPV helps management in making investment decisions.

If there is only one project, the only basis for decision-making is the positive amount of NPV.

Projects can also be compared easily if there are two or more projects of the same investment size.

#### Example

A company wants to invest \$5,000 in a project with a required rate of return of 7%.

The following are the cash inflows for a 3-year period:

Year 1 – (\$350)

Year 2 – \$1,500

Year 3 – \$3,000

NPV of the project  = \$(1568.1)

NPV results in a negative amount which means that the present value of cash outflow is higher than the present value of cash inflow.

In this case, investing in this project is not a good idea because it will only result in a loss.

## Disadvantages of Using Net Present Value

### Discounted Rate May Be Inaccurate

Discounted rate or cost of capital is needed to compute the net present value of all future cash flows. In some cases, the cost of capital is not always known, so distinguishing the appropriate discount rate may prove to be a challenge.

#### Example

A company wants to invest \$50,000, with the following inflows:

Year 1 – \$ 10,000

Year 2 – \$ 20,000

Year 3 – \$30,000

 Year Inflows Discounted to 5% Discounted to 7% Discounted to 9% 1 \$10,000.00 \$9,523.00 \$9,346.00 \$9,174.00 2 \$20,000.00 \$18,141.00 \$17,469.00 \$16,834.00 3 \$30,000.00 \$25,915.00 \$24,489.00 \$23,166.00 Total Cash Inflows \$60,000.00 \$53,579.00 \$51,304.00 \$49,174.00 Initial Investment \$50,000.00 \$50,000.00 \$50,000.00 \$50,000.00 Net Cash inflow (A-B) \$10,000.00 \$3,579.00 \$1,304.00 -\$826.00

It can be noticed that when the discount rate changes, the impact on the cash inflows is significant.

When the discounted rate is left to a company’s discretion, the computation may be erroneous hence, the projected net cash inflow may be misleading.

### Projects of Different Sizes Cannot be Compared

It will be difficult to compare two projects with different investment terms and sizes.

Some terms may apply to one project, while for the other it is not.

#### Example

The required investments and NPV for Projects A and B are the following:

 Project Investment Required NPV A \$100,000 \$75,000 B \$30,000 \$48,500

By considering the results of two different projects, in terms of profitability, Project A looks more profitable because the amount is higher than Project B.

In terms of return on investment, project B has a higher return on the invested capital.

### Hidden Costs

Net present value only focuses on how much a cost of invested capital may earn within a given period.

Other related costs incurred on the said project are not taken into consideration such as sunk costs, costs incurred in the preparation of the project, and any other hidden costs.

This means that ignoring such costs will not give the company an accurate NPV.

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1. Penn State "Net Present Value, Benefit Cost Ratio, and Present Value Ratio for project assessment" Page 1 . August 4, 2022

2. Illinois Institute of Technology "NPV calculation" Page 1 - 39. August 4, 2022