Net present value (NPV) is a common technique used in project analysis. It helps determine whether a project is viable and whether it will be profitable for the firm to pursue. It is a popular method as it:
1. Takes into account the time value of money
2. Determines the actual added value generated in pursuing the project
3. It is useful in distinguishing between a range of projects when a firm has limited resources
Net present value is determined by the present value of the stream of cash flow’s less the initial investment. A positive figure indicates that the project will add value and so should be pursued, while a negative value indicates that will not add value and so should not be pursued. The formula can be written as below:
NPV = -Co + c1/(1+r) + c2/(1+r)^2 …..
In the next article Net Present Value II, I will give you an example question, but before this I will highlight some important points that can often confuse students:
We are looking at cash flows not accounting profit. This means:
1. We must take into accounting working capital. Working capital is the cash and other current assets & Liabilities that arise from a project. This important because often a firm will hold a certain percentage of cash to pay for inventory and meet accounts payable, accounts receivable etc. This cash will be tied up in the project for the life of the investment. We must therefore recognise an increase in working capital as a cash outflow and the subsequent decrease in working capital as a cash inflow
2. We must ignore non-cash expenses such as depreciation.
3. We must take into account the purchase and sale of assets such as property, plant & equipment. Often a project requires an initial purchase of assets, followed by the subsequent sale in future periods
Tax is a cash expense yet the tax amount is determined by accounting profit. This means:
1. Although non cash expenses such as depreciation should not form part of the NPV calculation they do have a tax implication. Therefore we must recognise the reduced tax from the depreciation as a cash inflow. It can be calculated by: Cash Flow = Depreciation*Tax rate
Sunk costs must be ignored while opportunity costs must be included. This means
1. Expenses and cash flows prior to the current date must be ignored. i.e. If a firm has spent millions of dollars on research and is now deciding whether to develop the project this research must be ignored
2. Opportunity costs or in other words investments that a firm must forego to pursue the project must be included in the calculation. For example let’s pretend a project arises which requires 100m2 of floor space. If the firm already has this floor space but could rent it out, then the loss in rental revenue must be included in the NPV calculation
Below is an overview of the types of events you should look out for when caculating the NPV of a project:
‘We must therefore recognise an increase in working capital as a cash outflow and the subsequent decrease in working capital as a cash outflow’
is that written right?