The Net Present Value Method

Published Date: 02 Nov 2017

The primary goal of a corporation is to maximize the wealth of its stockholders. Taking this into account, long-term investments that will be undertaken by a firm should be evaluated based on their contribution to the wealth maximization goal. [i] The capital budgeting evaluation technique that clearly relates the capital investment to the wealth maximization goal is the net present value (NPV) method. The NPV is an amount that will instantly show whether the wealth of the owners will be increasing or decreasing given an investment opportunity. This is in contrast to other capital evaluation techniques such as internal rate of return (IRR), accounting rate of return (ARR) and payback period (PP) that expressed in percentage or time.

Under the NPV method, all cash inflows (benefit) or outflows (cost) related to the investment project are discounted at a minimum acceptable rate of return which is the firm’s cost of capital. Direct comparison between cost and benefit can only be meaningful if all cash flows relating to cost and benefit are expressed in similar term. This can only be done by converting all these cash flows into their equivalent value in a single point of time which is the present time, the time you will have to make a decision regarding investment opportunities. The difference between the two present values is called the net present value (NPV).

The decision based on NPV is straightforward. The project is acceptable if the present value of cash inflows is greater than the present value of cash outflows. That is, the project’s benefit is greater than its cost. If there are more than one project that have positive NPVs, the project with the higher or highest NPV should be selected. A positive NPV means that wealth of the stockholders will increase. The higher the NPV, the higher it will maximize wealth. Since NPV measures the impact that competing projects have on the value of the firm, choosing the project with the largest NPV is consistent with maximizing the wealth of the stockholders. [ii] 

The characteristics that make the NPV method superior over the other evaluation methods are the following: (1) considers the time value of money and the timing of cash flows in evaluating the project; (2) considers all cash flows over the entire life of the project; [iii] (3) it implicitly assumes that intermediate cash flows are reinvested at the project’s cost of capital. The payback period lacks all these three characteristics. The accounting rate of return does not consider the first and third characteristics. Nevertheless, the payback and ARR methods are still widely used by most firms because they are easy to understand and compute and data are readily available through the financial statements.

The evaluation method that comes closer to NPV in accurateness based on the three characteristics mentioned above is the IRR method. The NPV and IRR methods always lead to the same accept/reject decision for independent projects. However, in mutually exclusive projects, there may be a conflict in project choice between these two methods. Conflict can occur because of difference in project costs or cash flow timing. The cause of conflicts in project ranking lies also in differing reinvestment rate assumptions. IRR method implicitly assumes that the project cash flows are reinvested at the project’s IRR. The assumption of reinvestment at the cost of capital, as assumed by NPV method, is considered the more correct and realistic assumption. Thus, the NPV method is considered more superior than the IRR method. [iv] 

Some limitations, however, are associated with the use of the NPV method. Some say that the computations involved are quite difficult. However, this argument is no longer valid nowadays because of the ready availability of computer spreadsheet programs for the computations of present value figures. Another limitation of NPV is that computation of present values requires the use of a discount rate, such that if an overstated or understated rate is used, the evaluation would be misleading.

EXAMPLE PROBLEM:

You are assigned to evaluate two mutually exclusive projects. The data are given below:

Project A Project B

------------ -----------

Cost of investment $2,500,000 $1,500,000

Estimated useful life 10 years 10 years

Annual net cash inflows $450,000 $300,000

Discount rate 10% 10%

Compute the projects’ payback period.

Compute the projects’ NPV.

Compute the projects’ IRR.

Which project would you recommend? Why?

a)

Project A

Project B

Cost of investment

$2,500,000

$1,500,000

÷ Annual cash inflow

$450,000

$300,000

Payback period

5.56

5.00

b)

Year

PVIF @

Project A

Project B

10%

Cash inflow

Present value

Cash inflow

Present value

1

0.9091

450,000

409,091

300,000

272,727

2

0.8264

450,000

371,901

300,000

247,934

3

0.7513

450,000

338,092

300,000

225,394

4

0.6830

450,000

307,356

300,000

204,904

5

0.6209

450,000

279,415

300,000

186,276

6

0.5645

450,000

254,013

300,000

169,342

7

0.5132

450,000

230,921

300,000

153,947

8

0.4665

450,000

209,928

300,000

139,952

9

0.4241

450,000

190,844

300,000

127,229

10

0.3855

450,000

173,494

300,000

115,663

Present value of cash inflows

$ 2,765,055

$ 1,843,370

Less: Initial cost of investment

2,500,000

1,500,000

Net present value

$ 265,055

$ 343,370

c)

Year

Project A

Project B

Cash flow

Cash inflow

0

(2,500,000)

(1,500,000)

1

450,000

300,000

2

450,000

300,000

3

450,000

300,000

4

450,000

300,000

5

450,000

300,000

6

450,000

300,000

7

450,000

300,000

8

450,000

300,000

9

450,000

300,000

10

450,000

300,000

IRR

12.41%

15.10%

(Note: I used Excel's IRR() function.)

Project B is recommended because it has a lower payback period, a higher NPV and a higher IRR than Project A.

However, the final decision on capital investments should not be premised on quantitative considerations alone. The decisions is more than just a matter of ranking capital investment alternatives or selecting those that qualify because they meet some quantitative criteria or standard set by the firm such as maximum payback period or minimum desired rate of return. The qualitative factors must likewise be considered such as economic conditions, growth policies of the firm, risk evaluation and availability of funds.