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Net Present Value (NPV)

Sami Abulehya's Profile

What does a positive net present value mean? Example: Initial investment : 555,000 Annual net cash flow : 200,000 Number of periods : 4 years Discount rate : 10% Net present value : 79,000 I know it's worth to invest in , but how can i prove that the same is expected to earn 10% in addition to the NPV Amount (79,000)

Answers

Topic Expert
Patrick Dunne
Title: Chief Financial Officer
Company: Milk Source
(Chief Financial Officer, Milk Source) |

This is why all companies will take this one step further and establish an IRR hurdle (much higher than 10%) and make the investment if it meets that threshold.

david waltz
Title: Assistant Treasurer
Company: Integrys Energy Group
(Assistant Treasurer, Integrys Energy Group) |

The fact that the number is positive is the indication it is earning in excess of 10% - an investment earning exactly 10% would have a $0 NPV.

When using the hurdle rate method, it is still good to use NPV as well, as there is a danger of making inefficient decisions. For an extreme example, a $1 project that has a 100% return, and a $1 million project that has a 11% return. Using hurdle rates only, one would pick the first, yet the second yields higher actual dollar value ($10,000 vs. $1) - kind of the same thing as 100% of a small pie or 50% of a big pie...

For a constant dollar payment, you can add up the discount factors over the time horizon and then divide your initial investment by that amount, which will give you the annual payment required to exactly equal 10%. In this example it is $175.0863

Adam Hicks
Title: Capital Planner
Company: MHI
(Capital Planner, MHI) |

I find NPV works best when you are faced with multiple investment opportunities. For example you have 10 projects and perhaps they all present positive NPV. You can then simply line up your projects from highest NPV to lowest and pick the projects one by one up to the maximum you have to invest. A warning though as Patrick and David mentioned, you would never solely rely on NPV. Using Internal Rate of Return (IRR) is a great tool to understand and use in your analysis.

In a large organization, they should be analyzing all investment opportunities from all divisions/branches to ensure they are maximizing the return for capital expenditures. Not just what is best for each unit or division. It gets complicated however when management incentives are based on how much profit you can create for the organization. Those managers that have the art of selling can get a less desirable investment through executive over investments that can make more economical sense.

Robert Ewalt
Title: Exam Development Manager
Company: Institute of Certified Management Accoun..
(Exam Development Manager, Institute of Certified Management Accountants) |

A few points. I put the data into my financial calculator and found the IRR is 16.4%. This is more than the 10% discount rate, so the quick answer is to do the project. Similarly, the positive NPV (79k) says to do the project. NPV means discount each of the four flows by the discount rate, raised to power, and subtract the initial cost. But you cannot show that it will earn 10% more the 79k, because it won't. It will earn 6.4% more than the $79k.

More importantly, even with a positive NPV, you don't "know" it is worth it to invest in it. Not for sure. The $200k future flows have considerable uncertainty in them - what if the revenues are lower, or the costs are higher, than expected? Will this project eliminate other, more profitable, investment opportunities? Will it possibly hurt existing business (take away customers, management focus, promotion, etc.)?How appropriate is the 10% discount rate? Usually the discount rate comes from weighted average cost of capital, but is that appropriate for this project, for the next four years? If the discount rate goes up, the project looks less and less attractive - at a rate > 16.4% it will have a negative NPV.

phil Wolhar
Title: President/CEO
Company: PAWCO Enterprises, Ltd.
(President/CEO, PAWCO Enterprises, Ltd.) |

What this number means is if we invest $555,000 in this opportunity today, AND if our forecast of the benefits comes true (Big IF) this company will be worth $79000 more (in today's dollars) than it would have been worth had we not done this (over and above the cost of money) assuming 10% is Weighted Average Cost of Capital. IRR tells just how much greater the return is. I also like Profitability Index (PV Inflows divided by PV outflows) Anything greater than 1 is worth considering.

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