Overview
This lecture introduces Net Present Value (NPV), explains its calculation, application in investment decisions, and discusses its key advantages and disadvantages.
Net Present Value (NPV) Basics
- NPV is used to assess the profitability of a proposed project or investment.
- It considers all future cash inflows and outflows, adjusting for the time value of money.
- A positive NPV means the investment is likely profitable; a negative NPV suggests a loss.
Time Value of Money and Discounting
- The time value of money means a dollar today is worth more than a dollar in the future.
- Future cash flows are discounted using a discount rate (often the cost of capital) to reflect their present value.
- The formula sums present values of future cash flows and subtracts the initial investment.
Example of NPV Calculation
- Example: Invest $15,000 for projected $3,000 annual profit over 10 years at a 10% discount rate.
- Sum all discounted cash flows and subtract the initial investment; a result of $3,433.70 indicates profitability.
Advantages and Disadvantages of NPV
- Advantages: Considers time value of money, cost of capital, and discounts distant uncertain cash flows more heavily.
- Disadvantages: Highly depends on accuracy of inputs, not ideal for comparing projects of different sizes, ignores qualitative factors and hidden costs.
NPV vs. IRR (Internal Rate of Return)
- IRR is the discount rate that makes NPV zero and is used to compare returns to required rates.
- NPV shows absolute profitability; IRR helps compare projects of different sizes.
Frequently Asked Questions
- A "good" NPV is positive but relies on realistic cash flow and discount rate assumptions.
- Future cash flows are discounted due to time value of money and inflation, reflecting present decision-making needs.
Key Terms & Definitions
- Net Present Value (NPV) — The sum of present values of incoming and outgoing cash flows for an investment.
- Time Value of Money (TVM) — Principle that money available now is worth more than the same amount in the future.
- Discount Rate — The rate used to discount future cash flows to present value, often a company's cost of capital.
- Internal Rate of Return (IRR) — The rate that makes the NPV of all cash flows from a project equal to zero.
- Cost of Capital — The return rate a company needs to earn to justify an investment.
Action Items / Next Steps
- Practice calculating NPV and IRR for various project scenarios.
- Review and ensure accuracy of cash flow and discount rate estimates in investment proposals.