We already know that capital budgeting is the process companies use to decide on investments in new projects. When a company has many potential investment ideas, it needs methods to evaluate which projects are worth pursuing.
There are five common methods companies use to determine whether to accept or reject investment projects, one of which is calculating the Net Present Value (NPV) of a project.
Table of Contents
- What is Net Present Value (NPV)?
- What are the benefits of calculating Net Present Value (NPV)?
- How to Calculate Net Present Value (NPV)?
- How to make decisions based on Net Present Value (NPV)?
- What are called independent projects?
- Decision for Independent Projects:
- What are called mutually exclusive projects?
- Summary of Decision Criteria:
What is Net Present Value (NPV)?
In easy words, Net Present Value (NPV) is a financial metric that helps you figure out how much money you’ll make in the future compared to what you spend today.
NPV is considered the best method for evaluating projects because it directly aligns with the primary goal of financial management: maximizing shareholder wealth. It shows whether a project will increase or decrease the value of a company, which is crucial for making smart business decisions.
It takes into account the time value of money, meaning that it recognizes a dollar today is worth more than a dollar in the future. Other methods, like payback or IRR, may not fully capture this, making NPV a more reliable indicator.
What are the benefits of calculating Net Present Value (NPV)?
- Time Value of Money: NPV accounts for the fact that money has different values at different times. Future cash inflows are discounted back to their present value.
- Clear Decision-Making: It gives a clear “yes” or “no” answer. A positive NPV means a project is expected to add value; a negative NPV means it will reduce value
- Maximizes Wealth: By focusing on cash flows and the company’s cost of capital, NPV ensures projects align to increase shareholder value.
- Risk Sensitivity: NPV can be adjusted based on the risk level of the project by changing the discount rate.
How to Calculate Net Present Value (NPV)?
The basic formula for Net Present Value (NPV) is
$$ NPV = \sum \frac{CF_t}{(1 + r)^t} – CF_0 $$
Where:
- CF_t = cash flows in each period (cash inflows or outflows),
- r = the discount rate (usually the company’s cost of capital or required rate of return),
- t = time period,
- CF_0 = initial investment (cash outflow at time 0).
How to make decisions based on Net Present Value (NPV)?
The decision criteria of Net Present Value (NPV) are:
- Positive NPV: Accept the project, as it is expected to add value and increase shareholder wealth.
- Negative NPV: Reject the project, as it is expected to reduce value.
- Zero NPV: The project breaks even, meaning it neither adds nor reduces value. Depending on other strategic considerations, it could be accepted or rejected.
To better understand the Net Present Value (NPV) method, let’s explore two scenarios: independent projects and mutually exclusive projects.
What are called independent projects?
Independent projects are those where the decision to accept or reject one project does not affect the decision about other projects. In other words, if both projects are beneficial (i.e., both have positive NPVs), the company can choose to pursue both.
Imagine a company called EcoMotive, which manufactures electric vehicles. The company has two independent projects:
- Project A: Building a new production line for electric cars.
- Project B: Investing in solar panels for their manufacturing plant to reduce energy costs.
Each project has its own cash inflows and outflows and doesn’t impact the other. Let’s calculate the NPV for each project.
Project A (Electric Car Production Line):
- Initial investment: 2 million dollars
- Expected cash inflows over 3 years: 1 million dollars in year one, 1.2 million dollars in year two, and 1.5 million dollars in year three.
- Discount rate (cost of capital): 10%
$$ NPV_A = \frac{1,000,000}{(1 + 0.10)^1} + \frac{1,200,000}{(1 + 0.10)^2} + \frac{1,500,000}{(1 + 0.10)^3} – 2,000,000 $$ $$ NPV_A = 909,090.91 + 991,735.54 + 1,127,933.88 – 2,000,000 = 1,028,760.33 $$
Project A’s NPV is 1,028,760.33 dollars (positive), which means the project will add value to the company.
Project B (Solar Panel Investment):
- Initial investment: 500,000 dollars
- Expected cash inflows: 150,000 dollars each year for 5 years.
- Discount rate: 10%
$$ NPV_B = \frac{150,000}{(1 + 0.10)^1} + \frac{150,000}{(1 + 0.10)^2} + \cdots + \frac{150,000}{(1 + 0.10)^5} – 500,000 $$ $$ NPV_B = 136,363.64 + 123,966.03 + 112,696.39 + 102,451.27 + 93,137.52 – 500,000 = 68,614.85 $$
Project B’s NPV is 68,614.85 dollars (positive), meaning this project also adds value.
Decision for Independent Projects:
Since both Project A and Project B have positive NPVs, EcoMotive should accept both projects. Because they are independent, the company can invest in both projects, maximizing overall value creation for shareholders.
What are called mutually exclusive projects?
Mutually exclusive projects are those where accepting one project means rejecting the other. This often happens when two projects serve the same purpose, and the company can only choose one.
Business Story for Mutually Exclusive Projects
Now, suppose EcoMotive needs to choose between two projects for upgrading its manufacturing process. Both projects are mutually exclusive, meaning they perform the same function, and the company can only invest in one:
- Project X: Implementing a new robotics system.
- Project Y: Installing an automated assembly line.
Both projects aim to improve production efficiency, but the company can’t implement both due to resource limitations.
Project X (Robotics System):
- Initial investment: 3 million dollars
- Expected cash inflows: 1.5 dollars million in year one, 1.8 million dollars in year two, and 2 million dollars in year three.
- Discount rate: 10%
Following the same process of NPV calculation, we calculated the NPV and figured out that Project X’s NPV is 1,353,870.24 dollars (positive).
Project Y (Automated Assembly Line):
- Initial investment: 3 million dollars
- Expected cash inflows: 1.2 million dollars in year one, 2 million dollars in year two, and 2.5 million dollars in year three.
- Discount rate: 10%
We calculated the NPV and figured out that Project Y’s NPV is 1,622,250.52 dollars (positive).
Decision for Mutually Exclusive Projects:
Since these projects are mutually exclusive, EcoMotive can only choose one. Even though both projects have positive NPVs, Project Y has a higher NPV than Project X (1,622,250.52 vs. 1,353,870.24). Therefore, EcoMotive should choose Project Y because it adds more value to the company.
Summary of Decision Criteria:
- For independent projects: Accept all projects with positive NPVs because they each add value.
- For mutually exclusive projects: Choose the project with the highest positive NPV, as it will add the most value to the company.
I hope you understood the whole theory of NPV, if you have any confusion let me know in the comment box.
