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Principles of Finance

16.2 Net Present Value (NPV) Method

Principles of Finance16.2 Net Present Value (NPV) Method

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

Learning Outcomes

By the end of this section, you will be able to:

  • Define net present value.
  • Calculate net present value.
  • List the advantages and disadvantages of using the net present value method.
  • Graph an NPV profile.

Net Present Value (NPV) Calculation

Sam’s purchasing of the embroidery machine involves spending money today in the hopes of making more money in the future. Because the cash inflows and outflows occur in different time periods, they cannot be directly compared to each other. Instead, they must be translated into a common time period using time value of money techniques. By converting all of the cash flows that will occur from a project into present value, or current dollars, the cash inflows from the project can be compared to the cash outflows. If the cash inflows exceed the cash outflows in present value terms, the project will add value and should be accepted. The difference between the present value of the cash inflows and the present value of cash outflows is known as net present value (NPV).

The equation for NPV can be written as

NPV=PVCashInflows - PVCashOutflowsNPV=PVCashInflows - PVCashOutflows

Consider Sam’s Sporting Goods’ decision of whether to purchase the embroidery machine. If we assume that after six years the embroidery machine will be obsolete and the project will end, when placed on a timeline, the project’s expected cash flow is shown in Table 16.3:

Year 0 1 2 3 4 5 6
Cash Flow ($) (16,000) 2,000 4,000 5,000 5,000 5,000 5,000
Table 16.3

Calculating NPV is simply a time value of money problem in which each cash flow is discounted back to the present value. If we assume that the cost of funds for Sam’s is 9%, then the NPV can be calculated as

NPV = $2,0001.091 + $4,0001.092 + $5,0001.093 + $5,0001.094 + $5,0001.095 + $5,0001.096 - $16,000= $1,834.86 + $3,366.72 + $3,860.92 + $3,542.13 + $3,249.66 + $2,981.34 - $16,000= $2,835.63NPV = $2,0001.091 + $4,0001.092 + $5,0001.093 + $5,0001.094 + $5,0001.095 + $5,0001.096 - $16,000= $1,834.86 + $3,366.72 + $3,860.92 + $3,542.13 + $3,249.66 + $2,981.34 - $16,000= $2,835.63

Because the NPV is positive, Sam’s Sporting Goods should purchase the embroidery machine. The value of the firm will increase by $2,835.63 as a result of accepting the project.

Calculating NPV involves computing the present value of each cash flow and then summing the present values of all cash flows from the project. This project has six future cash flows, so six present values must be computed. Although this is not difficult, it is tedious.

A financial calculator is able to calculate a series of present values in the background for you, automating much of the process. You simply have to provide the calculator with each cash flow, the time period in which each cash flow occurs, and the discount rate that you want to use to discount the future cash flows to the present.

Follow the steps in Table 16.4 for calculating NPV:

Step Description Enter Display
1 Select cash flow worksheet CF CF0 XXXX
2 Clear the cash flow worksheet 2ND [CLR WORK] CF0 0
3 Enter initial cash flow 16000 +/- ENTER CF0 = -16,000.00
4 Enter cash flow for the first year ↓     2000 ENTER C01 = 2,000.00
    F01 = 1.0
5 Enter cash flow for the second year ↓     4000 ENTER C02 = 4,000.00
    F02 = 1.0
6 Enter cash flow for the third year ↓     5000 ENTER C03 = 5,000.00
    F03 = 1.0
7 Enter cash flow for the fourth year ↓     5000 ENTER C04 = 5,000.00
    F04 = 1.0
8 Enter cash flow for the fifth year ↓     5000 ENTER C05 = 5,000.00
    F05 = 1.0
9 Enter cash flow for the sixth year ↓     5000 ENTER C06 = 5,000.00
    F06 = 1.0
10 Select NPV NPV I 0.00
11 Enter discount rate 9 ENTER I = 9.00
12 Compute NPV ↓     CPT NPV = 2,835.63
Table 16.4 Calculator Steps for NPV1

Advantages

The NPV method solves several of the listed problems with the payback period approach. First, the NPV method uses the time value of money concept. All of the cash flows are discounted back to their present value to be compared. Second, the NPV method provides a clear decision criterion. Projects with a positive NPV should be accepted, and projects with a negative NPV should be rejected. Third, the discount rate used to discount future cash flows to the present can be increased or decreased to adjust for the riskiness of the project’s cash flows.

Disadvantages

The NPV method can be difficult for someone without a finance background to understand. Also, the NPV method can be problematic when available capital resources are limited. The NPV method provides a criterion for whether or not a project is a good project. It does not always provide a good solution when a company must make a choice between several acceptable projects because funds are not available to pursue them all.

Think It Through

Calculating NVP

Suppose your company is considering a project that will cost $30,000 this year. The cash inflow from this project is expected to be $6,000 next year and $8,000 the following year. The cash inflow is expected to increase by $2,000 yearly, resulting in a cash inflow of $18,000 in year 7, the final year of the project. You know that your company’s cost of funds is 9%. Use a financial calculator to calculate NPV to determine whether this is a good project for your company to undertake (see Table 16.5).

NPV Profile

The NPV of a project depends on the expected cash flows from the project and the discount rate used to translate those expected cash flows to the present value. When we used a 9% discount rate, the NPV of the embroidery machine project was $2,836. If a higher discount rate is used, the present value of future cash flows falls, and the NPV of the project falls.

Theoretically, we should use the firm’s cost to attract capital as the discount rate when calculating NPV. In reality, it is difficult to estimate this cost of capital accurately and confidently. Because the discount rate is an approximate value, we want to determine whether a small error in our estimate is important to our overall conclusion. We can do this by creating an NPV profile, which graphs the NPV at a variety of discount rates and allows us to determine how sensitive the NPV is to changes in the discount rate.

To construct an NPV profile for Sam’s, select several discount rates and compute the NPV for the embroidery machine project using each of those discount rates. Table 16.6 below shows the NPV for several discount rates. Notice that if the discount rate is zero, the NPV is simply the sum of the cash flows. As the discount rate becomes larger, the NPV falls and eventually becomes negative.

The information in Table 16.6 is presented in a graph in Figure 16.2. We can see that the graph crosses the horizontal axis at about 14%. To the left, or at lower discount rates, the NPV is positive. If you are confident that the firm’s cost of attracting funds is less than 14%, the company should accept the project. If the cost of capital is more than 14%, however, the NPV is negative, and the company should reject the project.

Discount RateNPV ($)
0%10,000
3%7,231
9%2,836
12%1,081
14%42
15%(442)
18%(1,773)
21%(2,939)
Table 16.6 NPV for Various Discount Rates
Net present value graph for Sam's Sporting Goods. It shows that the net present value, NPV, drops significantly as the discount rate goes up from 0% to 21%. When the discount rate is 0, the NPV is $10,000. However, when the discount rate is 21%, the NPV drops to negative $2,939.
Figure 16.2 NPV Profile Graph

Footnotes

  • 1The specific financial calculator in these examples is the Texas Instruments BA II PlusTM Professional model, but you can use other financial calculators for these types of calculations.
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