Management and shareholders are mainly concerned for the long term returns over investment. In a stable economy where some degree of certainty prevails companies prefer to invest in long term projects which require heavy investments initially and return is expected after or in many years to come. In a situation where inflation rates are high simple calculation of payback often give deceiving results because it does not consider time value of money. To calculate the exact return one must know the value of one dollar return today to be received after two or three years. The deteriorating value of money poses low value to one dollar after three years than its value today. The question arises how this deteriorating value of money should be dealt in evaluating the viability of long term projects. Various techniques are adopted in this regard like Internal Rate of Return, Profitability Index, and Net Present Value.

[adsense1]Net Present Value is the most superior of all techniques which discounts the expected cash flows over the period of the project by taking into account companies required rate or WACC. This is also called the discounted cash flow technique to the capital budgeting. Though Internal Rate of Return is also a discounted cash flow technique but it has some practical limitations therefore considered inferior to Net Present Value method. With the present value method, all cash flows are discounted to present value using the required rate of return. The Net Present Value of an investment proposal is the present value of all cash inflows over the period of the project less present value of cash out flows. If the resultant figure is zero or less than zero the project is rejected otherwise it is accepted. Another way to express the acceptance criterion is to say that the project will be acceptable if the present value of cash inflows exceeds the present value of cash outflows.

Calculating Net Present Value:

The NPV can be expressed as:

NPV = ((FV1 / 1+K) + (FV2 / (1+K)2 + (FV3 / (1+K)3 + ———- + (FVn / (1+K)n)) – I0

Where,

I0     =   Investment outlay
FV    =  The future values received in years 1 to n
K      =  The return available on equivalent risk security in the financial market

Example:

A company is evaluating two projects with an expected life three years and investment outlay of $ 1 million. The estimated net cash inflows for each project are as follows:

Years Project A Project B
$ $
1 300,000 600,000
2 1,000,000 600,000
3 400,000 600,000

The opportunity cost of capital for both projects is 10%.

Required: To calculate the NPV

Solution:

The NPV calculation for Project A is:

NPV = (($300,000 / 1.1) + ($1000,000 / (1.1)2 + ($400,000 / (1.1)3) – $1000,000
NPV = +$399,650

Or alternatively:

Year Amount Discount factor Present value
$ at 10%
1 300,000 0.9091 272,730
2 1,000,000 0.8264 826,400
3 400,000 0.7513 300,520
1,399,650
Less initial outlay 1,000,000
Net present value 399,650

The NPV calculation for Project B is:

Year Amount Discount factor Present value
$ at 10%
1 to 3 600,000 2.487 1,492,200
1,492,200
Less initial outlay 1,000,000
Net present value 492,200

The annual cash flow stream is similar therefore annuity factor is used.

Above both projects are acceptable. If one of them has to be selected than project B should be preferred because of higher net present value.

The rational behind acceptance criterion is the same as that behind the internal rate of return method. If the required rate of return is the return, the investors expect the firm to earn on the investment proposal, and the firm accepts the proposal with net present value greater than zero, the market price of the stock will rise. Again the firm is taking on a project with a return greater than that necessary to leave the market price of the stock unchanged.

Determining Relevant Cash Flows

Determination of relevant cash flows for discounting is perhaps the most difficult job in capital budgeting. It requires good analytical and conceptual skills on the part of a financial manager. Relevant cash flows often called free cash flows and are ascertained after complex computations.

Treatments of depreciation and taxation require theoretical and practical understanding of accounting and finance. As soon as free cash flows are determined with a quite a reasonable certainty calculation of Net Present Value becomes almost a trouble-free job.

Example:

A company earns a contribution of $ 75,000 each year over a Project’s life. Depreciation on straight-line basis is $ 25,000 each year and tax rate is 35%.

Required: To determine the relevant cash flow for each year.

Solution:

$
Contribution 75,000
Less Depreciation 25,000
Earning before tax 50,000
Tax @ 35% 17,500
Earning after tax 32,500
Add depreciation 25,000
Cash flow after tax each year 57,500

Net Present Value is a widely used evaluation technique in capital budgeting due to its practical implications and investors’ preferences because it takes into account only cash returns discounted at investors required rate of return which covers the whole period of the project or proposal.

In brief, the present value method is a theoretically correct technique for the selection of investment projects. Nevertheless, it has certain limitations also.

In the first place, it is difficult to calculate as well as understand and use in comparison with the pay back method or even the accounting rate of return method. This, of course, is a minor flaw. The second, and more serious problem associated with the present value method, involves the calculation of the required rate of return to discount the cash flows. The discount rate is the most important element used in the calculation for the present values because different discount rates will give different present values. The relative desirability of a proposal will change with the change in discount rate.