Post- 2
NPV v/s IRR
In today’s post of our series on NPV v/s IRR, we will focus on Net Present Value(NPV) and learn all about its General Procedure, Computation and Evaluation
General Procedure behind Discounted Cash Flow (DCF)
As the name suggests, this technique incorporates the Time Value of Money.
Thus, all the methods under this technique generally uses the cost of capital to discount cash flows. This makes sense as the cost of capital is the minimum discount rate on a project that leaves the market value unchanged and is thus in line with our objective.
Calculating the correct value of cost of capital is another matter!
(P.S.- There are different views regarding the correct manner to calculate the cost of capital)
Let us try to understand what we have discussed with an illustration!
All the readers are warned that the following illustration would include mathematics. The calculations used are very basic and can be easily understood with an elementary knowledge but if you want to skip (it’s not recommended), you can straight away move to the section ‘Using NPV Formula in Excel’
As discussed in our introductory post, benefits received sooner are more valuable than benefits received later. The basic reason behind this lies with the fact the former can be re- invested to earn a return. Thus, the Present value of $1000 will be less than $1000 now.
Cash flow at different time period differ in value and can be compared only when they are expressed in present values.
In our illustration, we receive benefits from the project to be undertaken at the end of each year.
Thus, column (B) represents cash inflows i.e benefits from a project at the end of (A)th year.
We use the Compound Interest formula for computation of (C) and (D).
n
FV= PV (1+k)
FV= Future Value
PV= Present Value
k= Cost of Capital/ Discount Rate
n= number of periods in the future cash inflows
In our illustration we will assume our discount rate i.e. the cost of capital to be 10%
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Therefore, the benefits received over a period of 3 years from now is equivalent to receiving $5124 now.
Net Present Value (NPV) Method
NPV is found by subtracting a project's initial investment from the present value of its cash inflows discounted at the firm’s cost of capital.
Continuing with our above illustration, if the initial cost outflow for the project is:
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$9000,
NPV= 9632- 9000
= 632
Net Benefits of the project is $632
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$10000,
NPV= 9632- 10000
= -368
Net loss from the project= $368
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$9632
NPV= 9632- 9632
= 0
No benefits gained
Using NPV Formula in Excel
Formula used:
=NPV(discount rate, series of cash flow)
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Computation using Excel
Formula used in Excel
Decision Rule
The above illustration can be generalised as the following rule:
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NPV> 0; Accept
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NPV>0; Reject
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NPV=0
This implies that only the initial investment is recovered, thus the chances of the project being accepted is rare
Usage
This method can be used to choose between different projects that compete with one another for acceptance. This basically means acceptance of one eliminates the other.
To compare, we calculate NPV for each project and then rank each project . The project with the highest rating would be ranked 1 and would be selected.
Merits
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Explicitly recognises time value of money
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Considers the totale benefits arising out of the proposal over its lifetime
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A changing discount rate can be built into NPV calculations.
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Useful for selection of mutually exclusive projects
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Useful in achieving the objective of maximisation of shareholders wealth
Limitations
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Computation is difficult as compared to the traditional techniques
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Calculation of cost of capital i.e. the required rate of return to discount the cash flows. It’s correct computation is important as its value would directly affect the desirability of the project.
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It is an absolute measure
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It might not give satisfactory results in case the projects have different life spans
