5.1 Net Present Value

Introduction

If you decide to pursue a course of action, what is the net benefit or cost of making that decision? How can you tell systematically which choice is financially superior?

Suppose that your marketing department thinks it has stumbled onto the next hot product to hit the market. The estimated research and development costs are [latex]\$10[/latex] million today with an expected [latex]\$5[/latex] million revitalization cost in five years. The product hits shelves in two years. Estimated year-end profits are [latex]\$4[/latex] million in the first three years and [latex]\$3[/latex] million for the subsequent two years. At that time, the rapid pace of technology will end the life cycle of the new product. This last year will earn an estimated [latex]\$1[/latex] million in profits. The funds needed for this project will be obtained at [latex]12\%[/latex] compounded annually. Does this project make financial sense? Your co-worker argues that the decision is clear: You would spend [latex]\$15[/latex] million to earn [latex]\$19[/latex] million, so the project should go forward. What do you think?

Your co-worker’s analysis summed the nominal numbers. This clearly violates the fundamental concept of time value of money—for example, you know that the projected profit of [latex]\$1[/latex] million in the last year of the product is not worth [latex]\$1[/latex] million today. To get an accurate picture of the potential benefit of this product, we need a technique that takes into account the time value of money.

What Is Involved in Making Monetary Business Decisions?

Investment decisions must consider both the type of decision being made along with the source of funding, which influences the interest rate used in financial calculations.

What type of decision is begin made?

Although there is no such thing as a “standard” or “normal” decision, many business decisions seem to fall into the same three categories.

• Making One Choice from Multiple Options. When you face a variety of options that will solve your problem, which option is financially the best?
• Deciding Whether to Pursue One Course of Action. When you face only one particular course of action, do you do it or not?
• Making Multiple Choices under Constraints. If you have limited resources and many different opportunities from which you can choose more than one, how do you select which opportunities to pursue and which to let pass by?

What monetary source is being used and what does it cost?

The structure of many decisions follows the old adage that you have to spend money to make money. Many courses of action require an investment up front (costs) to receive the reward (profits) in the future. This means you need to tap a source of money before you can go forward with any course of action. Individuals and corporations can access many of the same monetary sources, but businesses have additional options that are not available to individuals.

• Personal Funding Sources. You have limited options for obtaining money. Typically, you can either use debt financing such as a loan from a bank or a line of credit, or you can withdraw money from an investment fund or savings account.
  • If you borrow, the financial cost of the project is the interest rate that is being charged on the borrowed funds. For example, if you fund the project using a loan at [latex]8.5\%[/latex] compounded annually, the loan’s interest rate becomes the nominal rate you should use in the required time value of money calculations.
  • If you withdraw money from an investment, the cost of this project is the interest rate you forego on those funds. For example, if you take the money out of a GIC earning [latex]4\%[/latex] compounded annually, you should use the GIC’s interest rate in the decision calculations.
• Business Funding Sources. Businesses have substantially more choices than individuals when obtaining financing. In addition to debt financing and current investments, businesses also can issue bonds or use equity financing, such as offering company shares. Bartering with business partners is also possible. The same principle applies, though: whatever interest rate the funding source involves carries forward into any decision-making calculations.

Rate of return and cost of capital

The rate of return is the required rate of return that a business expects to receive from investing in the project. That is, the rate of return is what the business would earn by investing the same amount into a similar investment with the same risk. The rate of return is also know as the cost of capital, which is the cost of investing. Unless otherwise specified, the cost of capital is an interest rate that compounds annually.

As mentioned above, if the business does not have the funds on hand to invest in the project, some alternative funding source is required to carry out the project. In these cases the source of funding you use determines the cost of capital or interest rate in these calculations. If you use multiple sources to gather the needed funds, your interest rate is a weighted average of all the debt and equity financing rates. If you use a single source then the weighted average is simply the one source’s rate. This weighted interest rate is the cost of capital.

Cash Flows

A cash flow is a movement of money into or out of a particular project. Therefore, any time you incur a cost or receive a benefit on a particular project, you have a cash flow.

• When money is received, such as revenue or profit, you have a cash in-flow. Cash in-flows are recorded as positive.
• When money is paid out, such as an expense or a cost, you have a cash out-flow. Cash out-flows are recorded as negative.

As you work with these continuous cash flows, where to put an amount on the timeline depends on whether it is a cost or a benefit.

• Costs. Unless otherwise noted, capital costs are spent at the beginning of any time segment. Thus, if there are capital costs in year two, you can assume you incur them at the beginning of year two, which is the same as the end of year one.
• Benefits. Revenues, net profits (product sales minus product costs), or other benefits are realized at the end of any time segment. Thus, if there are net profits in year two, you can assume you realize them at the end of year two.

Net Present Value

The net present value ([latex]NPV[/latex]) method calculates the difference between all benefits and costs for any given project in today’s dollars. This decision-making technique calculates the value of all future cash in-flows and cash out-flows brought back to today (which serves as the focal date), using the rate of return or cost of capital as the interest rate. The word net means that the technique considers the invested money, all costs or expenses, along with all rewards such as profits in its calculations.

[latex]\boxed{5.1}[/latex] Net Present Value

• [latex]{\color{red}{NPV}}\;\text{is the Net Present Value:}[/latex] which is the value of all future cash in-flows and out-flows in today’s dollars
• [latex]{\color{blue}{\mbox{Sum of the }PV\mbox{ of Future Cash Flow}}}[/latex] represents the total present value of cash flow
• [latex]{\color{green}{\mbox{Initial Investment}}}[/latex] represents the original invested amount, which is subtracted from the cash flow calculation.

The initial investment is money spent today, and so is already at the focal date. Because most projects require advance funding, this amount represents a cash outflow today, against which you must net the present value of all future cash flows.

An alternative way to think of the net present value is that [latex]NPV[/latex] is the sum of the present value of the cash inflows minus the sum of the present value of the cash outflows. Because the initial investment is a cash outflow, the initial investment is included in the second sum. As above, today is used as the focal date and the present value of each cash flow is found at the focal date.

[latex]\displaystyle{NPV=\mbox{Sum of the } PV \mbox{ of Cash Inflows}-\mbox{Sum of the }PV \mbox{ of Cash Outflows}}[/latex]

The net present value nets out all costs and benefits. Here is how to interpret the [latex]NPV[/latex]:

• [latex]NPV=0.[/latex]The project repays the amounts of its investments plus the required cost of capital. In other words, the project breaks even. The business should accept the project.
• [latex]NPV>0.[/latex] The project provides returns that exceed its investments and the cost of capital. The project makes financial sense because it will add value to the company. The business should accept the project.
• [latex]NPV<0.[/latex] The project does not provide enough return to pay for its investments and the cost of capital. The project does not make financial sense because it will lose money for the business. The business should reject the project.

Of course, businesses often have many nonfinancial reasons for pursuing or not pursuing certain courses of action. These reasons are beyond the scope of this textbook.

Observe how [latex]NPV[/latex] relates to each of the three common types of business decision categories.

• Making One Choice from Multiple Options. You should choose the project with the highest NPV.
• Choosing Whether to Pursue One Course of Action. You should pursue the project if the NPV is greater than or equal to [latex]\$0[/latex].
• Making Multiple Choices under Constraints. You should choose the projects that maximize the total [latex]NPV[/latex].

Paths to Success

Create a table to record the cash flows for each time period. The table should record the cash inflows, the cash outflows, and the net cash flow for each time period. Alternatively, use a timeline to illustrate the cash flows for each time period.

Because cash flows can be inflows or outflows, write all numbers with their cash flow sign conventions in the table to avoid any confusion. That is, cash inflows are recorded as positive and cash outflows are recorded as negative. This helps you keep track of the different flows and minimizes the possibility of incorrectly netting out all present values.

Although the net present value can be found by finding the present value of all the future cash flows, as illustrated in the above example, this can be a cumbersome calculation when there are numerous cash flows over an extended period of time, even with the aid of a financial calculator. Most financial calculators include a cash flow worksheet and a built-in function to calculate the net present value.

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_{Video: Cash Flows 1: Net Present Value (NPV) and IRR Calculations by Joshua Emmanuel [2:52] Transcript Available.}

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