What is NPV – Net Present Value?
If you are in a Project Management or Financial position, you must have heard the word NPV many times. In fact, if you are analyzing a stock to buy, or reading an annual report, NPV must have crossed your mind.
What actually is NPV?
NPV stands for Net Present Value. It is a concept used to value a stream of future cash flows
NPV is based on theBig idea that a dollar today is worth more than a dollar tomorrow.
For instance, let’s assume that I pays you $1,000 today and $1,000 at the end of each of the next 4 years. Would that $5000 total be worth $5000 at the end of 4 years, of is it worth more than $5000 right now?
Actually, that would be worth less than $5,000 today. In fact, it would be worth:
1000 + (1000 / (1+r) 1) + (1000/ (1+r)2) + (1000/ (1+r)3) + (1000/ (1+r)4)
where r is a discount rate predefined by the organization.
In general, the formula to calculate NPV is -
NPV = CF0 + CF1/(1+r)1 + CF2/(1+r)2 …… + CFn/(1+r)n
The discount rate r is usually based on various factors like inflation rate, rate of interest, conversion rates etc.
So what does a Project or Project Manager has to do with NPV, you ask?
NPV calculations are used in a variety of contexts such as:
- Investors valuing a portfolio of bonds
- Companies valuing a potential acquisition
- Business managers valuing a new project
NPV is a measure of how much value an investment adds to a firm
- NPV > 0 —> project adds value
- NPV < 0 —> project subtracts value
NPV calculations require you to think about how a given project will create value for the organization and to quantify this value in terms of dollar amount.
What Discount rate should be used for NPV calculations?
Different firms use their weighted average cost of capital (“WACC”) as the discount rate.
WACC is a financing concept, and is calculated using a firm’s cost of equity, cost of debt, tax rate, and the relative weight of debt and equity in its capital structure.
WACC = E/V * Re + D/V * Rd * (1 – t)
Where E = value of firm’s equity , D = value of firm’s debt, V = E + D, t = corporate tax rate, Re = cost of equity, Rd = cost of debt.