Net Present Value (NPV)

Revision as of 22:00, 10 February 2022

Abstract

Big Idea

Project business case development is a critical point in a project where it gives a justification for undertaking a project, in terms of evaluating the benefits, cost, and risk of alternative options and the rationale for the preferred solution. Its purpose is to obtain management commitment and approval for investment in the project. In a business case, financial appraisal plays a key role to answer the fundamental economic questions of whether an investment should be made and which project should be chosen among a selection of different alternatives. The task of financial appraisal is to forecast the financial effects of a planned investment and to present the data in such a way that a a reasoned investment decision can be reached.

The net present value (NPV) method is the most frequently used approach in the financial appraisal of a project.

What is NPV?

The net present value (NPV) is the difference between the present value of all future incoming cash flows and the present value of all future outgoing cash flows. NPV is a widely used method in the financial appraisal that considers the time value of money by applying discounting and compounding of all payment series during the investment period. Time value of money is that money you have in hand now is more valuable than the money you collect later on. That is because you can use it to make more money by running a business, buying something now and selling it later for more, or simply putting it in the bank and earning interest. Future money is also less valuable because inflation erodes its buying power.

Assumptions of NPV

The NPV of a project is calculated based on the following assumptions:

• All the future cash flows are translated to present value by discounting them at the.
• The inflow or outflow of cash other than the initial investment occur at the end of each period.
• The discount rate or cost of capital remains same throughout the life of the project.
• The cash generated by a project is immediately reinvested at the cost of capital.

Formula

As a summary, the following steps are recommended for the calculation of the Net present value:

1. Determination of the initial outflow for the investment.
2. Estimate the expected net cash flows from the investment for

each period of the planning horizon. 3. Determination of the discount uniform rate (it is assumed that the discount rate remains unchanged over the life of the investment), in other words, the rate of return required by the investor. 4. Discounting of the expected net cash flows with the discount rate to the time period when the investment is made (determination of the present value). 5. Subtraction of the initial outflow for the investment from the present value. This yields the net present value (NPV).

Applications

Limitations

Annotated Bibliography

Reference Example: According to scientists, the Sun is pretty big.^[1] The Moon, however, is not so big.^[2]

References

1. ↑ E. Miller, The Sun, (New York: Academic Press, 2005), 23–25.
2. ↑ R. Smith, "Size of the Moon", Scientific American, 46 (April 1978): 44–46.

Actual Reference: According to scientists, the Sun is pretty big.^[1] The Moon, however, is not so big.^[2]

References

1. ↑ Häcker J., Ernst D. Investment Appraisal. In: Financial Modeling. Global Financial Markets., (Palgrave Macmillan, London, 2017), https://doi.org/10.1057/978-1-137-42658-1_8
2. ↑ R. Smith, "Size of the Moon", Scientific American, 46 (April 1978): 44–46.