Understanding Net Present Value
Net present value (NPV) is a method used by businesses to determine whether investments (projects) are worthwhile or not. We introduce NPV in the Test of Competence Finance course and then re-visit at a more complex level in Test of Professional Skills Advanced Finance.
The basic premise behind NPV is that a project is worthwhile undertaking if the returns outweigh the costs. Often, project costs are incurred upfront but returns are received in the future, therefore a direct comparison of costs and returns is not feasible, as the time value of money concept would be ignored. It is therefore necessary to discount the future returns back to today and then compare this present value to the costs to determine whether a project should be undertaken.
There are five key points to remember when completing an NPV calculation:
1. NPV is based on cash flows.
Therefore, the analysis of the costs and returns should be based on cash being paid or received and not on accounting profits. All changes to cash flows that occur as the result of the new project should be incorporated into the NPV analysis.
2. Any financing cash flows should be excluded from the NPV analysis.
Do not include cash flows that relate to debt or equity payments or receipts. This includes loan capital receipts and repayments, loan interest payments, overdraft interest payments, dividend payments, share issues and buybacks.
3. Assume that cash flows occur at the end of each year, unless you are specifically told otherwise.
A cash flow received in year one of the project is received at the end of year one and should be discounted for a full year. If you are specifically told that a cash flow takes place at the beginning of a year, it should be included in the previous year. So, if you are told a cash flow is received at the beginning of year three, this is effectively the same as the end of year two and the cash flow should be discounted for two years.
4. Discount the future cash flows at the weighted average cost of capital (WACC).
This is the average cost of finance of the business. If WACC is used as the discount rate we have effectively incorporated the cost of finance into the NPV analysis. This is why finance cash flows are ignored, as the impact of finance is included by using the WACC as the discount rate.
5. Conclude whether the project is worthwhile or not.
This is done by subtracting the initial cost of the project from the present value of the future cash inflows. If the initial cost exceeds the present value of cash inflows the project is not worthwhile and should not be undertaken. If the present value cash inflows exceed the cost the project is worthwhile and should be undertaken.
Top tips for NPV calculations:
- Use a table format – show the years across the columns and each separate cash flow as a row.
- Show workings in Advanced Finance questions. This reduces the loss of marks due to calculation errors.
- Remember that tax can also be included as a cash flow. These are cash outflows for corporation tax payments and often the equipment will be subject to a capital allowance that will reduce the tax bill.
- The WACC is only a suitable discount rate if the project under consideration will be funded in the same way as the rest of the business and represents the same level of risk.
- Don’t forget to conclude appropriately!