Net income

Project appraisal - discounted cash flow.

(NPV).

Net present value is a discounted cash flow technique.

It expressly recognises that the timing of project cash flows is important, as well as the amounts.

It makes future cash flows with different timings directly comparable.

Net present value is the total present value of all of the cash flows of a proposal - both positive and negative - netting off negative present values against positive ones.

For example, the expected future cash inflows from an investment project LESS the initial capital investment outflow at Time 0.

Each present value (PV) is calculated as:

PV = Future value x Discount factor (DF)

Where:

DF = (1 + r)^-n

r = cost of capital per period; and

n = number of periods into the future that the cash flow is expected

Example 1: cost of capital 10%

A project requires an investment today of $100m, with $120m being receivable one year from now.

The cost of capital (r) is 10% per annum.

The NPV of the project is calculated as follows:

PV of Time 0 outflow $100m

= $(100m) negative

PV of Time 1 inflow $120m

= $120m x 1.1^-1

= $109.09m

NPV = -$100m + $109.09m

= +$9.09m (positive)

Decision rule

In very simple Net Present Value analysis for investments, the decision rule would be that:

(1) All positive NPV investment opportunities should be accepted.

(2) All negative NPV investment opportunities should be rejected.

So the project in the example above would be accepted (on the basis of this simple form of the NPV decision rule) because its NPV is positive, namely +$9.09m.

However this assumes the unlimited availability of further capital with no increase in the cost of capital.

A more refined decision rule is that:

1. All negative NPV investment opportunities should still be rejected; while
2. All positive NPV investment opportunities remain eligible for further consideration (rather than automatically being accepted).

NPV drivers

NPV is driven by the amounts of forecast cash flows, their timing, and the cost of capital.

Example 2: cost of capital rises to 20%

Taking the same example of a project requiring an investment today of $100m, with $120m being receivable one year from now.

The cost of capital (r) rises to 20% per annum.

The NPV of the project is now calculated as follows:

PV of Time 0 outflow $100m

= $(100m)

PV of Time 1 inflow $120m

= $120m x 1.2^-1

= $100m

NPV = -$100m + $100m

= $NIL

Now the project decision is marginal, following the change in the cost of capital assessment.

Example 3: cost of capital rises further to 30%

Continuing with the same example of a project requiring an investment today of $100m, with $120m receivable one year from now.

The cost of capital (r) rises further to 30% per annum.

The NPV of the project would now be calculated as follows:

PV of Time 0 outflow $100m

= $(100m)

PV of Time 1 inflow $120m

= $120m x 1.3^-1

= $92.31m

NPV = -$100m + $92.31m

= -$7.69m (negative)

Now the project would be rejected, following the further rise in the cost of capital evaluation.

See also

• Capital rationing
• Cost of capital
• Discounted cash flow
• Economic value added
• Future value
• Internal rate of return
• Investment appraisal
• Present value
• Residual theory
• Time value of money
• Weighted average cost of capital