Decide and Evaluate Project Value with Net Present Value (NPV)
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Your vision is to have a quick way to evaluate projects.
The dilemma is you have several projects in front of you that all seem highly beneficial to the business. The issue is, time and resources are always limited, so which would you choose? Where would you start to figure out which to go with?
Defining a case for using Net Present Value or NPV
The case is a business looking to determine whether they could generate a higher return by investing in factory expansion into t-shirts or handbags. T-shirts will require an upfront investment of $40,000 and handbags $60,000.
The solution is to look at the Net Present Value, or NPV formula, and compare the projects.
What is NPV?
For the purpose of this article, the general term project will refer to any business activity being considered, whether it’s valuing a business, capital project, cost reduction program, etc. that will involve cash flow of some sort and that is expected to generate a financial return to the business. Projects will generate revenue at different rates and times. Some will generate a quick return, and others take months or longer. NPV looks at the revenue stream from the future, or the value of all future cash flows over the life of an investment, in terms of today’s value. This is because one dollar today is worth more than one dollar in a month because that dollar could be used to earn a return. This formula reduces the cash flows you expect to earn in the future because of the time delay.
The actual definition is the difference between the present value of cash inflows and the present value of cash outflows over a period of time.
Why would one use NPV?
When you’re making the decision to move a project forward, you need to consider two things. First is whether the return expected will be more than if you could’ve invested that money into something else and made more that way, and second, which of the projects to choose from provides the highest expected return.
How would you know if NPV is good or bad?
The goal is always a positive NPV as those are the appealing projects that will bring a positive cash flow, negative won’t necessarily lose money, but the return will be less than the discount rate (read more below), which means you should probably consider investing in something else because you could get a higher return elsewhere. The higher the NPV, the better, as that gives insight into which of the projects will return the greatest profit. You could think of it as a positive NPV will create value for the business.
What do you need to plug into NPV?
Formula:
NPV = ((Cash flow) / (1+i) ^t) – (initial investment)
(Or check out that link for a handy calculator!)
What do the inputs mean:
Cash flow: The amount of money you expect to be generated in each time period.
i: The required return or discount rate. This is what a project has to generate to make sense to invest in for your business.
t: The number of time periods.
Initial investment: The total you will have to spend to get this project going.
NPV examples from our case
NPV of Project T-shirts
Cash flow: Year 1 $20,000, Year 2 $25,000, Year 3 $30,000
i: 10%
t: 3 years
Initial investment: $40,000
NPV = ($20,000/(1 + .10) ^1 + $25,000/(1 + .10) ^2 + $30,000(1 + .10)^3) - $40,000
NPV of T-shirts= $21,382.42
NPV of Project Handbags
Cash flow: Year 1 $25,000, Year 2 $35,000, Year 3 $45,000
i: 10%
t: 3 years
Initial investment: $60,000
NPV of Handbags = ($25,000/(1 + .10) ^1 + $35,000/(1 + .10) ^2 + $45,000(1 + .10)^3) - $60,000
NPV of Handbags = $25,462.06
You can see in this basic example that handbags have a higher NPV despite the higher upfront investment. Based on your inputs, it would seem that handbags could be a better investment choice at this time.
Are there any negatives to NPV?
As in all of the other articles in this blog, it needs mention that this is yet another tool to use, but it’s important to note, it’s just one tool, and you need to take the big picture into account.
1. Like many predictive models, you have to make assumptions. Documenting those assumptions is key so that there is complete transparency and record.
2. The discount rate is always the same.
3. There could be other things going on in the business that a formula just can’t capture, so your years of experience must come into play here.
4. It’s possible for bias towards a project you feel strongly about to creep in here in making those assumptions.
5. The size of the project isn’t taken into account, and the length of time to implement.
Run a few of your upcoming projects through this exercise to see where it comes out at and comment how it went!
Written by Nicole Hullihen, July 11th, 2021
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References I recommend if you want to learn more
CFI Institute. (n.d.). Net Present Value (NPV). Corporate Finance Institute. Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/valuation/net-present-value-npv/.
Thakur, M. (n.d.). Net Present Value Formula. EDUCBA. Retrieved from https://www.educba.com/net-present-value-formula/.
Jagerson, J. (2021, Jan 16). What is the formula for calculating net present value (NPV)? Investopedia. https://www.investopedia.com/ask/answers/032615/what-formula-calculating-net-present-value-npv.asp.