Net Present Value (NPV) models

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What is 'Net Present Value - NPV'?

Net Present Value is the difference over a period of time between the present value of cash outflows and the present value of cash inflows. NPV is used in capital budgeting when analyzing the profitability of a project or projected investment.

A net present value that is positive signifies that the projected earnings of a project or investment are due to exceed the expected costs. Usually, a project that has a positive NPV will make profit for the company, whilst a project with a negative NPV will cause a net loss. The concepts serves as the basis for the Net Present Value Rule which advises that you should only make investments with positive NPV values.

If the investment that you are considering is a merger or an acquisition, you may also consider using the Discounted Cash Flow metric. Aside from the formula, methods of calculating net present value include tables and spreadsheets using Excel.

It is challenging to work out the value of a project because there are different methods of measuring future cash flows’ values. Due to the time value of money, present money is worth more than the same amount will be in the future. This is due to earnings that could be made potentially using the money at the time of the intervening time and due to inflation. Put simply, a dollar that is earned in the future will not be worth the same value as one that is earned right now. You can account for this using the discount rate element of the net present value formula.

Businesses usually have different methods of identifying the discount rate. You can determine the discount rate by using other investment choices with a level of risk that is similar and using their expected return, or using the costs linked to borrowing money that you will need to fund the project.

Net Present Value Disadvantages and Alternatives

One problem with estimating the profitability of a project with net present value is that it heavily relies upon many estimates and assumptions, so generally there is a lot of room for error. Projected returns, investment costs, and discount rates are all estimated. A lot of the time, a project can require unexpected spending when getting it up and running or when finishing.

As well as this, cash flow approximations and discount rates may not always inherently account for any risk linked with the project and could assume the max. cash inflows possible over an investment period. This can occur as a way of artificially adding to investor confidence. Because of this, it may be necessary to adjust these factors to account for unexpected losses or costs for cash inflow projections that have been overly optimistic.

Payback Method is a popular method frequently used alternatively to net present value. It is more basic than NPV, principally gauging the time that is required post-investment to recoup the investment’s initial costs. However, unlike NPV, the payback method doesn’t account for the time value of money. Because of this, payback periods that are calculated for longer investments are more likely to be inaccurate, as more time is encompassed during which time inflation may occur and skew the earnings that have been projected, and therefore, the real payback period also.

As well as this, the payback period is limited to the period of time that is required to make back the initial costs of investment. It also does not account for the profitability of an investment after the investment reaches the end of the payback period. As a result, the rate of return of the investment could experience a sharp drop or increase. Therefore, it is hard to make accurate comparisons regarding the profitability of these investments.

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