5 minutes of reading
What is NPV
About how one simple indicator determines the investment attractiveness of a project.
Content
- How to calculate NPV?
-
23.10.2024
What is NPV
NPV (Net Present Value) is an indicator that helps to assess the profitability of investments in a project. NPV makes it clear to investors how much profit the project will bring and whether it is worth investing in it.
It is one of the main indicators that should be taken into account when choosing a project for investment. It can be used to calculate whether a project will bring income to an investor for, for example, 10 years, when investments take place over three.
How to calculate NPV?
The NPV of the project shows how much money the project will be able to bring in excess of the investment. The indicator is calculated taking into account the fact that money is more expensive now than in the future: it can still be used to make additional profit, for example, to put it into a deposit account.
- The NPV indicator itself is the sum of the payment flows discounted at a certain rate and reduced to the present day, minus the initial investment.
Discounting is the calculation of the present value of future income or expenses based on the selected interest rate. Money loses its value over time, so a discount rate is applied, which allows you to bring future income to the current point in time.
The following formula is used to calculate NPV:
where:
- CFt – cash flows in period t,
- r – discount rate,
- t – the period number,
- IC – the initial investment.
If the NPV is positive, the project promises to be profitable. If it is negative, then the project may turn out to be unprofitable, and its implementation should be abandoned or the plan changed.
Let's give an example.
The company decides whether to launch a new product. The project requires an investment of $120,000 immediately and another $6,000 annually for 6 years. At the same time, a profit of $36,000 is expected each year. But the company can also invest the profit in the bank at 10% per annum.
The task of a financial analyst is to determine whether the launch of a new product will be more profitable than the contribution of this money at interest. To do this, he uses NVP:
- The value of each cash flow in current money is calculated.
- The value of all cash flows is added up.
Год
Денежный поток
Приведённая стоимость
T=0
−100000(1+0.10)^0
– $ 120 000
T=1
36000−6000(1+0.10)^1
$ 27 273
T=2
36000−6000(1+0.10)^2
$ 24 793
T=3
36000−6000(1+0.10)^3
$ 22 539
T=4
36000−6000(1+0.10)^4
$ 20 490
T=5
36000−6000(1+0.10)^5
$ 18 627
T=6
36000−6000(1+0.10)^6
$ 16 934
The sum of all values is $10,656.
NPV is greater than zero, which means that the project will bring in more money than if the money were invested in a bank. This means that it will bring profit, and the investor should invest in it.
NPV formula of the project allows you to take into account not only the amount of future income, but also their "weight", taking into account the time value of money.
What is good and bad about NPV?
The net present value should be taken into account when choosing a project for investment, as well as its advantages and disadvantages.
+ Versatility
NPV can be calculated for any long-term project: company development, construction of facilities, product range expansion, and so on. The calculation, if all the necessary data is available, will be equally simple for any of them.
+ The ability to compare different projects
For example, if an investor is considering two projects with different investments and incomes, he can calculate the NPV of each of them. The project with the highest positive NPV will be the most profitable in terms of profit.
- The subjective discount rate
The NVP depends on the discount rate, which may be inaccurate and does not reflect the real risks of the project. This distorts the real picture of the profitability of the project.
- Not taking into account the economies of scale
NPV is ineffective for comparing projects of different scales, because it does not take into account this effect. A higher indicator for a large project may be related to its size, rather than greater profitability.
NVP is not the only indicator that needs to be taken into account when choosing projects for investment. It may contradict others, and then deeper calculations will be required.
NPV shows what profit can be expected from the project, taking into account the time value of money. It is important to take it into account when choosing a project for investment, but you should not rely only on it: NVP has its weaknesses.
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