Net Present Value (NPV): Present value of cash flows minus initial investments, The Net Present Value (NPV) method as an investment appraisal or capital budgeting technique shows how an investment project affects company shareholders’ wealth in present value terms. Maximizing shareholders’ wealth is an important goal for management, and investment projects with positive NPV are wealth-enhancing and should be accepted.
Net Present Value
Net Present Value (NPV): The difference between the present value of cash inflows and the present value of cash outflows.
When we analyze whether to invest in a particular project or not, or to choose between two or more projects, the most simple and commonly used test is to calculate the NPV. Unlike some techniques where the time value of money is not given due importance, NPV is calculated by keeping in mind the concept of the time value of money, that is, the effect of inflation and other factors is also considered here. Must Check Petty Cash Book.
Now the question is:
How do we calculate the Net Present Value?
To calculate the NPV, we should predict the future cash inflows, ascertain the future cash outflows, and determine a rate at which discounting is to be done (to calculate the time value of money). Let us do this with the help of an example:
Eg. ABC Ltd. is planning to invest in one of these two projects. Project – A involves an Initial Cash Outflow of Rs. 10 Lacs, and the estimated cash inflow is say, Rs. 4 Lacs per annum for the next 4 years. Project B involves an initial Cash Outflow of Rs. 12 Lacs, and estimated cash inflows are say, Rs. 5 lacs per annum for the next 4 years. The rate of discounting to be considered is 15%.
Solution:
| Particulars | Project – A | Project – B |
| [A] Cash In flow | Rs. 4 Lacs | Rs. 5 Lacs |
| [B] PVAF @ 15% for 4 years | 2.8550 | 2.8550 |
| [C] Present Value of Cash Inflows { A * B } | Rs. 11.42 Lacs | Rs. 14.28 Lacs |
| [D] Initial Cash Outflow | Rs. 10 Lacs | Rs. 12 Lacs |
| [E] Net Present Value { C – D } | Rs. 1.42 Lacs | Rs. 2.28 Lacs |
As seen above, the Net Present value for both projects is positive. So, if we have an option to choose multiple projects, we can opt for both of them. However, if we had a negative NPV for either of these projects, we would have rejected the same. You may also like Rules of Debit and Credit.
In the above case, we had to choose only one of the above-mentioned projects. So, we will choose the project that offers the maximum NPV and also suits our investment aspects. So, if the management of the company agrees, choosing Project B over Project A is more beneficial to the company.
Now you must be wondering what should the company do when the NPV comes to be 0, well, when the Net Present Value is 0, it is upon the management of the company to decide whether to accept or reject the project. However, it is generally seen that in such cases, the project is accepted by the management. This is so because the rate of discounting is an approximate guess of the management and is generally a little higher as compared to the actual scenario.
Thus, NPV is a good technique to ascertain whether a project is acceptable or not. There are some other techniques as well which you will get to know in my following articles. Must Check Basic earnings per share.
