Net Present Value (NPV)

Capital Budget

The Net Present Value (NPV) method is based on the present value of the expected monetary gain or loss from a project. All expected cash inflows and outflows are discounted to the beginning of the project, using the required rate of return. The NPV of an investment or project is the difference between the present value of all future expected cash inflows and the present value of all (initial and future) expected cash outflows, using the required rate of return.

Thus, a project’s NPV is the present value of its future expected cash inflows minus the present value of its future expected cash outflows. The initial cash outflow occurs at the very beginning of the project, so that amount is not discounted (or if it is, it is “discounted” by multiplying it by 1.0). Some projects may have other net cash outflows (negative cash flows) in subsequent years of the project. If so, those future negative  cash flows are also discounted and the discounted cash outflow amounts are also deducted from the present value of the project’s future expected cash inflows.

The present value of the expected cash flows is calculated using a discount rate that is the company’s
required rate of return (RRR), which is one of two options:

  1. The return the company can expect to receive in the market for an investment of comparable risk.
  2. The minimum rate of return that the project must earn to justify investment of the resources.

This required rate of return is also called the discount rate, hurdle rate, or opportunity cost of capital.
Generally, the company’s cost of capital is used as the discount rate. However, the required rate of return
used to discount the future expected cash flows and compute the NPV must be appropriate to the project’s risk. 

Relevant expected cash flows used in the Net Present Value capital budgeting analysis include:

  • Initial net cash outflows, including the cost of the asset or assets and increased working capital requirements.
  • Initial cash inflow from the sale of existing assets if new assets are replacing existing assets, net of the tax effect of any gain or loss.
  • Net cash outflows that may be expected to occur subsequent to the beginning of the project, such as additional investments required during the project.
  • Operating cash inflows (increased revenues and reduced expenses) net of related income taxes.
  • Operating cash outflows (expected operating losses or increased expenses) net of the related reduction in income taxes.
  • Tax savings from the depreciation tax shield.
  • Cash proceeds from the sale of the asset at the end of the project, net of the tax effect of any gain or loss on the sale.
  • Working capital released at the end of the project.

Recall that in discounted cash flow analysis, unless otherwise directed, always assume that all expected cash flows occur at the end of the year. The net present value that results will be slightly understated because cash flows actually occur uniformly throughout each year. However, the net present value will be usable because any inaccuracy introduced by that assumption will not be material to the analysis and would not cause a change in the decision.

Using NPV

In general, any project with a positive NPV should be accepted because these projects will increase shareholder wealth. Conversely, any project with a negative NPV should be rejected. However, perhaps due to limited funds or certain nonfinancial factors, not all projects with positive NPVs will be chosen. Therefore, a more accurate statement is that any project with a positive NPV is a candidate for further consideration.

When a firm has limited funds to invest, NPV enables management to rank the various projects according
to the amount that each one is expected to return.

In working with the cash flows, remember that even though depreciation is a non–cash expense, it
does have a cash flow impact through reduction of the income taxes paid.

Benefits of the Net Present Value Method of Capital Budgeting

  1. It provides an estimate of the profitability of a project and the amount of change in shareholder wealth that should take place if the project is undertaken.
  2. It takes into consideration the time value of money.
  3. Net present value incorporates the impact of all the cash flows associated with the project.
  4. It can be used to manage risk in a project by adjusting the required rate of return used as the discount rate to compensate for projects with higher or lower risk than the company’s current projects.
  5. NPV enables ranking of potential projects according to their expected returns, which is useful when
    a firm has limited funds for capital projects.

Limitations of the Net Present Value Method of Capital Budgeting

  1. NPV incorporates an assumption that all cash inflows from the project will be reinvested at the required rate of return, which may not be the case and which may lead to an incorrect evaluation of the project’s true worth.
  2. Since the NPV is expressed as a monetary amount, it does not provide an expected rate of return on the investment.
  3. There is the risk of incorrect assumptions, which can affect the validity of the results.
  4. The net present value is very sensitive to the discount rate used, and that rate is subject to estimation.
  5. The firm’s actual cost of capital may vary significantly from the discount rate used in the NPV analysis due to market fluctuations, which can cause the actual change in shareholders’ value to be different from the initial estimates.
  6. NPV is not useful for comparing projects of different sizes.
  7. Cash flows beyond the initial expected lifetime of the project are not recognized in an NPV analysis but can provide additional shareholder value
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