Net Present Value (NPV) is the most used technique of capital investment appraisal. In simple terms, net present value is the value of net cash flows arising from the project after discounting it with discounting factor, also known as the cost of capital.
Under this method, the initial investment is compared to discounted revenues. Under another approach, the sum of all cash flows is compared to the sum of all cash inflows. Both the inflows and outflows are discounted using a cut off rate or desired rate of interest.
For example, if a machine is purchased in the year 2019 for $10,000. It would be considered as cash outflow. Now, let say net cash flows arising from this investment are $3,000 in 2020, $5,000 in 2021 and $4,000 in the year 2022. Here the simple sum of outflows is $3,000+5,000+4,000 = $12,000. It seems that investment has positive cash flows of $2,000. However, it is not the case. The above-mentioned cash flows are non-discounted. After discounting the scenario might change.
Let’s say the desired rate of interest is 10%. Now the discounted vales will become $2727.27, 4132.23 and 3005.26 and sum of discounted cash flows will be 9,864.76, which is lesser than the initial investment and makes the investment non-feasible. However, if the required rate of return is lesser than 10%, say 6% or 7% it still might be a good investment.
Decision Criteria: A project should be accepted if the net present value of the project is positive or more than zero. If NPV is 0 or negative it should be rejected.
A five-step approach can be utilized to compute the NPV:
- Determine the cost of the project
- Estimate the project’s future cash flows over its forecasted life
- Determine the riskiness of the project and estimate the appropriate cost of capital
- Compute the project’s NPV
- Make a decision