Net Present Value NPV is the current value of an asset or a project whose cash flow is discounted with a suitable interest rate. The cash flows from the investments are after tax numbers.
NPV determines the present value of the investment with both cash inflows and cash outflows of the firm in the future. The method of NPV, throws light on time value of money, inflation can also be used as a discount rate when cash is sitting idle, this adds more meaning to the value of money at different time horizons. Nevertheless the present value of money can be found, the value of money or investment can be found at any point in lifetime of the asset or project.
When a real estate property is leased, the net present value of the lease deteriorates exponentially, this is easily compensated by a high return project undertaken on the property.
In theory, NPV assures the effect increase or decrease in stock price because the method is directly related to the firm’s value. In practice it is much more complicated.
How net present value is calculated?
Assume a machinery bought for INR 10,00,000 which produces 1,00,000 cash flow every year till it attains the depreciation limit, 10th year. -10,00,00 at time zero as an investment (out flow), cash flows are constant until t=10. Applying the formula,
1,00,000/10,00,000 is 10% return every year
-10,00,000 + 1,00,000/(1+0.1) + 1,00,000*0.8264 + 1,00,000*0.7513 + …… + 1,00,000/(1.1)^10
= -10,00,000 + 6,15,000
If the raw payback method is used, the machine would have repaid the investment amount in 10 years. When discounted payback is used, the machine should outlive the depreciation period to return back in full or to be bought for less than INR 6,15,000.
Net Present Value (NPV) vs Internal Rate of Return (IRR):
The problem with NPV and IRR is, the values differ in size of the project and the corresponding value added to the firm. On the whole a low investment high return project may be suitable when considered individually or when the size of the project is significant to affect the value of the firm drastically. A high investment project producing relatively lesser returns adds more value to the firm. NPV is high for a low return high value project and IRR will be high for a high return, relatively less value project. As the organisation soars, the size of the project is given more importance than the realised return ( as they contribute immense value to the firm) from the project. Firms that select projects that are both bigger and high return is no lesser than a stellar performer.
Another problem with using the parallel method, is IRR, IRR never assures reinvestment returns that are same as the initial investment return. The relation between IRR and NPV is implausible to explain with finite words.
Can net present value be negative?
Net present value is negative when, the investment is an underperformer and is a terrible investment removing cash initially. Conventional cash flows are negative initially and when turned positive remains positive until the project dies.
Why net present value is important?
Net Present Value portrays the time value of money, in narrow eyed personal finance the returns from investments are calculated as undiscounted values to the present day, a calculation of NPV discloses what the present value of the investment is. Net present value higher the better, for projects the payback period or pay back method solely is uncertain when NPV is neglected. NPV doesn’t make it fuller but eliminates the vital uncertainty of the payback period. Using NPV it takes more time to pay back the investment than a raw form of the method.