Net present value analysis

Net present value is the difference between the present values of the cash inflows and cash outflows experienced by a business over a period of time. Any capital investment involves an initial cash outflow to pay for it, followed by cash inflows in the form of revenue, or a decline in existing cash flows that are caused by expense reductions. We can lay out this information in a spreadsheet to show all expected cash flows over the useful life of an investment, and then apply a discount rate that reduces the cash flows to what they would be worth at the present date. This calculation is known as net present value analysis. Net present value is the traditional approach to evaluating capital proposals, since it is based on a single factor – cash flows – that can be used to judge any proposal arriving from anywhere in a company.

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Example of Net Present Value

ABC International is planning to acquire an asset that it expects will yield positive cash flows for the next five years. Its cost of capital is 10%, which it uses as the discount rate to construct the net present value of the project. The following table shows the calculation:

The reason why the discount rate has a greater impact on cash flows further away in time is that these cash flows are worth less, since you have to wait longer to receive them.

The Net Present Value Formula

The discount rate is included in present value tables that are readily available in books on accounting and finance. Discount rates can also be calculated using the following formula:

Present value of Future cash flow
a future cash flow = -----------------------------------------------------------------------------------
(1 + Discount rate) (Squared by the number of periods of discounting)

Using the preceding formula, if there is an expectation of receiving $150,000 in one year, and the current discount rate is assumed to be 10%, then the calculated net present value of the future cash receipt is:

Present value = $136,363.64

Disadvantages of Net Present Value

Though net present value analysis is heavily used, it does have some flaws. They are as follows:

• Discount factor is subject to interpretation. One is that the discount factor used in the calculation is derived from a firm’s cost of capital - which can be a somewhat hazy concept. The cost of capital can be calculated within a range, based on how you interpret its cost of equity. Given that the cost of capital can lie within a range, the use of an excessively low cost of capital can result in net present values that are too high, so that investments are accepted that should have been rejected. Conversely, an estimated cost of capital that is too high will result in net present values that are too low, so that investments are rejected that should have been accepted.
• Not good for investments of different sizes. Net present value analysis does not work well when comparing proposed investments of different sizes. Since the outcome of this analysis is stated in dollars, a high-profit investment might be rejected in favor of a lower-profit investment if the total cash flows from the lower-profit investment are larger. For example, a $5 million investment that generates a $100,000 net present value would be accepted over a $50,000 investment that generates a $25,000 return - even though the $50,000 investment generates a higher percentage return.

Additional Net Present Value Factors

There can be a considerable number of variations on the possible cash flows associated with a business decision, making the net present value calculation more difficult to derive. The following factors may need to be considered:

• Throughput on goods sold. If the decision relates to an investment that will result in the sale of goods, include cash flows from the throughput generated by these goods. Throughput is revenue minus all totally variable expenses.
• Cash from sale of asset. If an asset is to be purchased, also assume that some cash will be received at a later date from the eventual sale of that asset.
• Maintenance costs. If there will be incremental costs incurred to maintain a purchased asset, include the cash flows associated with these costs. Do not include any cash flows related to maintenance personnel who will still be paid, irrespective of the presence of the asset.
• Working capital. If there will be an incremental change in the amount invested in accounts receivable or inventory as the result of a purchase decision, include these cash flows in the analysis. If the asset is to be eventually sold off, this may mean that the related working capital investment will be terminated at the same time.
• Tax payments. Include any property taxes related to assets that are acquired. Also, include the amount of any incremental income taxes paid, if the acquired asset generates profits.
• Depreciation effect. Include the effect on income taxes paid of the depreciation expense associated with an acquired asset. This effect is caused by the tax deductibility of depreciation.

In short, net present value analysis is an effective way to aggregate the cash flows associated with a business decision that are spread over a number of time periods, though some analysis may be required to accumulate all of the relevant cash flows.