3.7 - Net Present Value Flashcards
Define net present value
is the difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyse the profitability of a projected investment or project.
What is the discount cash flow method
To get the present value we used what is called as discount cash-flow method, which is a technique that considers how interest rates affect the present value of future cash flows.
To use this method we need to use a “discount factor” to convert the future net cash flow to its present value today.
Given the fact that receiving money today its worth more than receiving money in the future, the “discount factor” can represent either interest rate or inflation.
LOOK AT DISCOUNT NET PRESENT VALUE METHOD TABLE AMD EXAMPLE
How do we analyse the table on page 6
➢In this case the NPV is £126,248 , a positive value that means that the project should go ahead and its viable.
➢Of course, if the value was negative, the project shouldn’t be pursued.
➢An increase in the discount rate reduces the NPV because future cash flows will be worth less when discounted rates are higher.
➢Note that the total amount of the net cash flow (£850,000) is obviously more that the total of the present value (£ 726,248) in the same period of time. Confirming the theory that money now is worth more than in the future.
How do you solve example 2 on page 8
A new machine for a firm will cost £300,000 and it should last 5 years. Maintaining it will cost £50,000 per annum but will increase the value of the firms output by an estimated £150,000. Interest rates are currently at 5%. Calculate the NPV for the proposed investment.
➢Again, the positive value (£132,940) of the NPV makes the project viable.
➢Its is also very important o see that if we do not use the NPV the expected return could be deceiving. In this specific case, could lead us to think that it will be £200,000 (£500,000-£300,000) when in reality is much less than that (£132,940) . Thant’s why the NPV is the most realistic approach to estimate future returns.
➢In summary, cash received in the future has not the same value as cash received today because the money could have been invested. Hence, it is important to calculate the NPV to compare the returns of investments over different time periods.
