Net Present Value Analysis
What is Net Present Value?
Any capital investment involves an initial cash outflow to pay for it, followed by cash inflows in the form of revenue, or a decline in existing cash flows that are caused by expense reductions. We can lay out this information in a spreadsheet to show all expected cash flows over the useful life of an investment, and then apply a discount rate that reduces the cash flows to what they would be worth at the present date. This calculation is known as net present value analysis.
Net present value is the traditional approach to evaluating capital proposals, since it is based on a single factor – cash flows – that can be used to judge any proposal arriving from anywhere in a company.
Net Present Value Example
ABC International is planning to acquire an asset that it expects will yield positive cash flows for the next five years. Its cost of capital is 10%, which it uses as the discount rate to construct the net present value of the project. The following table shows the calculation:
|Year||Cash Flow||10% Discount Factor||Present Value|
|Net Present Value||-$7,196|
The net present value of the proposed project is negative at the 10% discount rate, so ABC should not invest in the project.
The Discount Rate
In the “10% Discount Factor” column, the factor becomes smaller for periods further in the future, because the discounted value of cash flows are reduced as they progress further from the present day. The discount factor is widely available in textbooks, or can be derived from the following formula:
|Present value of a future cash flow||Future cash flow|
|(1 + Discount rate)squared by the number of periods of discounting|
To use the formula for an example, if we forecast the receipt of $100,000 in one year, and are using a discount rate of 10 percent, then the calculation is:
Present value = $90,909
Contents of a Net Present Value Analysis
A net present value calculation that truly reflects the reality of cash flows will likely be more complex than the one shown in the preceding example. It is best to break down the analysis into a number of sub-categories, so that you can see exactly when cash flows are occurring and with what activities they are associated. Here are the more common contents of a net present value analysis:
- Asset purchases. All of the expenditures associated with the purchase, delivery, installation, and testing of the asset being purchased.
- Asset-linked expenses. Any ongoing expenses, such as warranty agreements, property taxes, and maintenance, that are associated with the asset.
- Contribution margin. Any incremental cash flows resulting from sales that can be attributed to the project.
- Depreciation effect. The asset will be depreciated, and this depreciation shelters a portion of any net income from income taxes, so note the income tax reduction caused by depreciation.
- Expense reductions. Any incremental expense reductions caused by the project, such as automation that eliminates direct labor hours.
- Tax credits. If an asset purchase triggers a tax credit (such as for a purchase of energy-reduction equipment), then note the credit.
- Taxes. Any income tax payments associated with net income expected to be derived from the asset.
- Working capital changes. Any net changes in inventory, accounts receivable, or accounts payable associated with the asset. Also, when the asset is eventually sold off, this may trigger a reversal of the initial working capital changes.
By itemizing the preceding factors in a net present value analysis, you can more easily review and revise individual line items.
Cautions when using Net Present Value
Net present value does not consider the presence of a constraint in the system of generating cash flow, which could restrict the total amount of cash actually generated. The result can be an estimated net present value that cannot be realized.