Net Present Value - NPV
What is Net Present Value?
The valuation technique, known as net present value or NPV, allows a company to project the projects potential profitability by discounting future cash flow expectations and comparing the sum of these cash flows to the initial capital expenditure required to fund the project.
Future cash flows must be discounted to perform an apples to apples comparison. For example, $100 today is not the same as $100 in 3 years. $100 today will have the opportunity to earn risk-free compounded interest for 3 years and therefore will have a value which is higher than $100 at the end of 3 years. This is why we must discount or remove the interest component from the future cash flow, allowing us to put the initial capital investment and future cash flows on a level playing field.
Below, you will see the formula for calculating net present value. Basically, we are discounting each future cash flow by a discount factor to arrive at the present value of each cash flow. The formula then sums up each of these values and subtracts the intial investment into the project. A NPV greater than 0 indicates that the project will add value to the company, while a NPV of less than 0 indicates that the company will be negatively impacted by the project; however, it may need to proceed with the project for purposes of damage control or further loss prevention.
There is a grey area where the NPV is near 0 or at 0. In this case, management will have to decide if there are intangible benefts such as increased brand awareness or leadership in bringing a product to market which will postively influence the company down the road.
Disadvantages of Net Present Value
The formula displayed above looks pretty straight forward, and it is. It does not account for many of the real world risks involved with undertaking a new project. Management risk, uneven cash flows, taxes, and other investment options create uncertainty that this calculation does not account for. For example, a company may find itself in a position of generating uneven cash flows due to differing costs at differing stages of a project.
While it should not be ruled out in every case, increasing the discount rate to compensate for additional risk can pose problems if a project has negative cash flows at some point. A higher discount rate will lessen the true impact of the loss. A secondary impact of increasing the discount rate to account for risk lies in the compounding of this risk premium over time. It will start to exponentially increase the discount rate and drastically reduce the NPV which may not be very accurate.