Quantifying Net Present Value
Net present value helps management or potential investors weigh the wisdom of an investment by enabling the expected benefits to be quantified. It is used in investment control to gauge whether a potential project will be profitable and would be applied, for example, when assessing the feasibility of buying more plant to increase production.
The net present value of anticipated income from sales of what will be produced during the life of the plant is discounted back at an interest rate consistent with any risk involved to the date the investment is made. The calculation will produce a figure for each year and, if the total for all the years exceeds the sum of the capital to be invested, the profitability of the project can be assessed, or the potential investment compared with alternatives—as basic as depositing the capital in a savings account paying a better rate of interest. Of course, if the net present value is less than the capital, the investment will not be profitable.
Management is considering the purchase of new plant to increase production, and in the process balancing factors like installation costs, additional revenue generated by additional output, and the taxes on this revenue. The cash flows management projects to be generated are:
| Year One | $100,000 (initial cost of investment) |
| Year Two | $30,000 |
| Year Three | $40,000 |
| Year Four | $40,000 |
| Year Five | $35,000 |
| Net Total | $145,000 |
The time value of money unfortunately reduces this estimated return on the new plant substantially, since future dollars are worth less than present dollars. Net present value accounts for these differences with the help of present-value tables, readily available on the Internet and in reference books. These tabulate the ratios that express the present value of expected cash flows, based on the applicable interest rate and the number of years in question.In the example above, cost of capital is 9%. Using this figure to find the corresponding ratios on the present value table, the $100,000 investment cost, and the expected annual revenues during the five years in question, the net present value calculation appears as:
| Cash Flow | Table Factor (at 9%) | Present Value | |
| Year One | $100,000 × | 1 = | $100,000 |
| Year Two | $30,000 × | 0.92 = | $27,523.93 |
| Year Three | $40,000 × | 0.84 = | $33,667.20 |
| Year Four | $40,000 × | 0.77 = | $30,887.32 |
| Year Five | $35,000 × | 0.71 = | $24,794.88 |
Net present value is therefore $16,873.33. It is still positive, so, on this basis at least, the investment would be sound.
- Beware of assumptions. Interest rate changes can affect net present value dramatically, while new revenues and new markets may not grow as projected. If the cash flows in years two to five in the example fall by $5,000 a year, for instance, net present value shrinks to $5,260.89, which is still positive, but less attractive.
- The calculations are performed only with cash receipts payments and discounting factors, and it must be kept in mind that net present value is only a tool. It ignores other accounting data, intangibles, sheer faith in a new idea, and other factors that may make an investment worth pursuing in spite of a negative net present value.
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