Net Present Value (NPV)
Written by Deepthi Tharaka Parana Liyanage Don- s203116
Contents |
Abstract
Financial appraisal is a method used to evaluate the viability of a proposed project or portfolio of investment projects by evaluating the benefits and costs that result from its execution. Investment decisions of the management are critical to a company since it decides the future of the company. This article discusses the Net Present Value (NPV) method which is widely used in financial appraisal. NPV is a dynamic financial appraisal method that considers the time value of money by applying discounting and compounding of all payment series during the investment period[1]. In simple terms, the net present value is the difference between an investment object’s incoming and outgoing payments at present time. NPV is determined by calculating the outgoing cashflows (costs) and incoming cash flows (benefits) for each period of an investment. After the cash flow for each period is calculated, the present value (PV) of each one is achieved by discounting its future value using the suitable discount rate. Net Present Value is the cumulative value of all the discounted future cash flows[2].
Firstly, this article discusses the idea behind the Net Present Value method and its underlying assumptions. Then this introduces the NPV calculation method[1] and describes the importance of the variables in the formula such as discount rate. Also, it highlights the decision criteria behind NPV and explains it with a real-life application. Finally, it critically reflects on the limitations of this method and briefly introduces the other alternative financial apprisal methods such as Internal Rate of Return (IRR), payback method, and Return on Investment (ROI).
Big Idea
The net present value (NPV) method is the most frequently used approach in the financial appraisal of a project. This section highlights the background & relevancy of this topic.
What is NPV?
This section explain the concept of NPV
Assumptions of NPV
This highlights the underlying assumptions in NPV
Formula
This section introduces the NPV formula & recommended steps in the calculation of the NPV.
Example Formula:
In order to consider the time value of money the net present value method considers the value of an investment at the present time by converting all information of the future into a key figure at the time today. To get the present value of future cash flows, they are discounted based on an interest discount rate (i) and the time of cashflow (t) using:
Where:
– Present Value
- time of the cashflow
- Cash inflows in period t
– Cash outflows in period t
– Net cashflow in period t
– The discount rate
Discount Factor
This section describes how to select the discount factor and its importance.
Time period
Decision rule
This gives the decision criteria of NPV.
Applications
Application of NPV in real example
Limitations
Introduce the limitations of NPV
Alternative financial appraisal methods
This section gives a brief idea about other methods
- IRR
- payback
- ROI
Annotated Bibliography
Reference Example: The book-1.[1] The book-2.[2] The book-3.[3] The book-4.[4] The book-5.[5]
References
- ↑ 1.0 1.1 1.2 Häcker J. and Ernst D., Ch. 8 - Investment Appraisal. In: Financial Modeling. Global Financial Markets., (Palgrave Macmillan, London, 2017), pp. 343-384, https://doi.org/10.1057/978-1-137-42658-1_8
- ↑ 2.0 2.1 Ferrari, C., Bottasso, A., Conti, M. and Tei, A., Ch. 5 - Investment Appraisal. In: Economic role of transport infrastructure: Theory and models., (Elsevier, 2018), pp. 85-114, https://doi.org/10.1016/C2016-0-03558-1
- ↑ Konstantin P. and Konstantin M., Ch. 4 - Investment Appraisal Methods. In: Power and Energy Systems Engineering Economics., (Springer, Cham, 2018), pp. 39-64, https://doi.org/10.1007/978-3-319-72383-9_4
- ↑ Poggensee K. and Poggensee J., Ch. 3 - Dynamic Investment Calculation Methods. In: Investment Valuation and Appraisal., (Springer, Cham, 2021), pp. 85-140, https://doi.org/10.1007/978-3-030-62440-8
- ↑ Ing E. and Lester A., Ch. 6 - Investment Appraisal. In: Project Management, Planning and Control. 7th Edition., (Elsevier, 2017), pp. 29-36, https://doi.org/10.1016/B978-0-08-102020-3.00006-1
