# Net present value

Last updated

In finance, the net present value (NPV) or net present worth (NPW) [1] applies to a series of cash flows occurring at different times. The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the discount rate. NPV accounts for the time value of money. It provides a method for evaluating and comparing capital projects or financial products with cash flows spread over time, as in loans, investments, payouts from insurance contracts plus many other applications.

Finance is a field that is concerned with the allocation (investment) of assets and liabilities over space and time, often under conditions of risk or uncertainty. Finance can also be defined as the art of money management. Participants in the market aim to price assets based on their risk level, fundamental value, and their expected rate of return. Finance can be split into three sub-categories: public finance, corporate finance and personal finance.

The time value of money is the greater benefit of receiving money now rather than an identical sum later. It is founded on time preference.

## Interpretation as integral transform

The time-discrete formula of the net present value

${\displaystyle \mathrm {NPV} (i,N)=\sum _{t=0}^{N}{\frac {R_{t}}{(1+i)^{t}}}}$

can also be written in a continuous variation

${\displaystyle \mathrm {NPV} (i)=\int _{t=0}^{\infty }(1+i)^{-t}\cdot r(t)\,dt}$

where

r(t) is the rate of flowing cash given in money per time, and r(t) = 0 when the investment is over.

Net present value can be regarded as Laplace- [6] [7] respectively Z-transformed cash flow with the integral operator including the complex number s which resembles to the interest rate i from the real number space or more precisely s = ln(1 + i).

${\displaystyle F(s)=\left\{{\mathcal {L}}f\right\}(s)=\int _{0}^{\infty }e^{-st}f(t)\,dt}$

From this follow simplifications known from cybernetics, control theory and system dynamics. Imaginary parts of the complex number s describe the oscillating behaviour (compare with the pork cycle, cobweb theorem, and phase shift between commodity price and supply offer) whereas real parts are responsible for representing the effect of compound interest (compare with damping).

## Example

A corporation must decide whether to introduce a new product line. The company will have immediate costs of 100,000 at t = 0. Recall, a cost is a negative for outgoing cash flow, thus this cash flow is represented as −100,000. The company assumes the product will provide equal benefits of 10,000 for each of 12 years beginning at t = 1. For simplicity, assume the company will have no outgoing cash flows after the initial 100,000 cost. This also makes the simplifying assumption that the net cash received or paid is lumped into a single transaction occurring on the last day of each year. At the end of the 12 years the product no longer provides any cash flow and is discontinued without any additional costs. Assume that the effective annual discount rate is 10%.

The present value (value at t = 0) can be calculated for each year:

YearCash flowPresent value
T = 0${\displaystyle {\frac {-100,000}{(1+0.10)^{0}}}}$−100,000
T = 1${\displaystyle {\frac {10,000}{(1+0.10)^{1}}}}$9,090.91
T = 2${\displaystyle {\frac {10,000}{(1+0.10)^{2}}}}$8,264.46
T = 3${\displaystyle {\frac {10,000}{(1+0.10)^{3}}}}$7,513.15
T = 4${\displaystyle {\frac {10,000}{(1+0.10)^{4}}}}$6,830.13
T = 5${\displaystyle {\frac {10,000}{(1+0.10)^{5}}}}$6,209.21
T = 6${\displaystyle {\frac {10,000}{(1+0.10)^{6}}}}$5,644.74
T = 7${\displaystyle {\frac {10,000}{(1+0.10)^{7}}}}$5,131.58
T = 8${\displaystyle {\frac {10,000}{(1+0.10)^{8}}}}$4,665.07
T = 9${\displaystyle {\frac {10,000}{(1+0.10)^{9}}}}$4,240.98
T = 10${\displaystyle {\frac {10,000}{(1+0.10)^{10}}}}$3,855.43
T = 11${\displaystyle {\frac {10,000}{(1+0.10)^{11}}}}$3,504.94
T = 12${\displaystyle {\frac {10,000}{(1+0.10)^{12}}}}$3,186.31

The total present value of the incoming cash flows is 68,136.91. The total present value of the outgoing cash flows is simply the 100,000 at time t = 0. Thus:

${\displaystyle \mathrm {NPV} =PV({\text{benefits}})-PV({\text{costs}})}$

In this example:

${\displaystyle \mathrm {NPV} =68,136.91-100,000}$
${\displaystyle \mathrm {NPV} =-31,863.09}$

Observe that as t increases the present value of each cash flow at t decreases. For example, the final incoming cash flow has a future value of 10,000 at t = 12 but has a present value (at t = 0) of 3,186.31. The opposite of discounting is compounding. Taking the example in reverse, it is the equivalent of investing 3,186.31 at t = 0 (the present value) at an interest rate of 10% compounded for 12 years, which results in a cash flow of 10,000 at t = 12 (the future value).

The importance of NPV becomes clear in this instance. Although the incoming cash flows (10,000 × 12 = 120,000) appear to exceed the outgoing cash flow (100,000), the future cash flows are not adjusted using the discount rate. Thus, the project appears misleadingly profitable. When the cash flows are discounted however, it indicates the project would result in a net loss of 31,863.09. Thus, the NPV calculation indicates that this project should be disregarded because investing in this project is the equivalent of a loss of 31,863.09 at t = 0. The concept of time value of money indicates that cash flows in different periods of time cannot be accurately compared unless they have been adjusted to reflect their value at the same period of time (in this instance, t = 0). [2] It is the present value of each future cash flow that must be determined in order to provide any meaningful comparison between cash flows at different periods of time. There are a few inherent assumptions in this type of analysis:

1. The investment horizon of all possible investment projects considered are equally acceptable to the investor (e.g. a 3-year project is not necessarily preferable vs. a 20-year project.)
2. The 10% discount rate is the appropriate (and stable) rate to discount the expected cash flows from each project being considered. Each project is assumed equally speculative.
3. The shareholders cannot get above a 10% return on their money if they were to directly assume an equivalent level of risk. (If the investor could do better elsewhere, no projects should be undertaken by the firm, and the excess capital should be turned over to the shareholder through dividends and stock repurchases.)

More realistic problems would also need to consider other factors, generally including: smaller time buckets, the calculation of taxes (including the cash flow timing), inflation, currency exchange fluctuations, hedged or unhedged commodity costs, risks of technical obsolescence, potential future competitive factors, uneven or unpredictable cash flows, and a more realistic salvage value assumption, as well as many others.

A more simple example of the net present value of incoming cash flow over a set period of time, would be winning a Powerball lottery of $500 million. If one does not select the "CASH" option they will be paid$25,000,000 per year for 20 years, a total of $500,000,000, however, if one does select the "CASH" option, they will receive a one-time lump sum payment of approximately$285 million, the NPV of \$500,000,000 paid over time. See "other factors" above that could affect the payment amount. Both scenarios are before taxes.

## Common pitfalls

• If, for example, the Rt are generally negative late in the project (e.g., an industrial or mining project might have clean-up and restoration costs), then at that stage the company owes money, so a high discount rate is not cautious but too optimistic. Some people see this as a problem with NPV. A way to avoid this problem is to include explicit provision for financing any losses after the initial investment, that is, explicitly calculate the cost of financing such losses.
• Another common pitfall is to adjust for risk by adding a premium to the discount rate. Whilst a bank might charge a higher rate of interest for a risky project, that does not mean that this is a valid approach to adjusting a net present value for risk, although it can be a reasonable approximation in some specific cases. One reason such an approach may not work well can be seen from the following: if some risk is incurred resulting in some losses, then a discount rate in the NPV will reduce the effect of such losses below their true financial cost. A rigorous approach to risk requires identifying and valuing risks explicitly, e.g., by actuarial or Monte Carlo techniques, and explicitly calculating the cost of financing any losses incurred.
• Yet another issue can result from the compounding of the risk premium. R is a composite of the risk free rate and the risk premium. As a result, future cash flows are discounted by both the risk-free rate as well as the risk premium and this effect is compounded by each subsequent cash flow. This compounding results in a much lower NPV than might be otherwise calculated. The certainty equivalent model can be used to account for the risk premium without compounding its effect on present value.[ citation needed ]
• Another issue with relying on NPV is that it does not provide an overall picture of the gain or loss of executing a certain project. To see a percentage gain relative to the investments for the project, usually, Internal rate of return or other efficiency measures are used as a complement to NPV.
• Non-specialist users frequently make the error of computing NPV based on cash flows after interest. This is wrong because it double counts the time value of money. Free cash flow should be used as the basis for NPV computations.

## History

Net present value as a valuation methodology dates at least to the 19th century. Karl Marx refers to NPV as fictitious capital, and the calculation as "capitalising," writing: [8]

The forming of a fictitious capital is called capitalising. Every periodically repeated income is capitalised by calculating it on the average rate of interest, as an income which would be realised by a capital at this rate of interest.

In mainstream neo-classical economics, NPV was formalized and popularized by Irving Fisher, in his 1907 The Rate of Interest and became included in textbooks from the 1950s onwards, starting in finance texts. [9] [10]

## Alternative capital budgeting methods

• Adjusted present value (APV): adjusted present value, is the net present value of a project if financed solely by ownership equity plus the present value of all the benefits of financing.
• Accounting rate of return (ARR): a ratio similar to IRR and MIRR
• Cost-benefit analysis: which includes issues other than cash, such as time savings.
• Internal rate of return (IRR): which calculates the rate of return of a project while disregarding the absolute amount of money to be gained.
• Modified internal rate of return (MIRR): similar to IRR, but it makes explicit assumptions about the reinvestment of the cash flows. Sometimes it is called Growth Rate of Return.
• Payback period: which measures the time required for the cash inflows to equal the original outlay. It measures risk, not return.
• Real option: which attempts to value managerial flexibility that is assumed away in NPV.
• Equivalent annual cost (EAC): a capital budgeting technique that is useful in comparing two or more projects with different lifespans.

## Related Research Articles

Discounting is a financial mechanism in which a debtor obtains the right to delay payments to a creditor, for a defined period of time, in exchange for a charge or fee. Essentially, the party that owes money in the present purchases the right to delay the payment until some future date. The discount, or charge, is the difference between the original amount owed in the present and the amount that has to be paid in the future to settle the debt.

In economics and finance, present value (PV), also known as present discounted value, is the value of an expected income stream determined as of the date of valuation. The present value is always less than or equal to the future value because money has interest-earning potential, a characteristic referred to as the time value of money, except during times of negative interest rates, when the present value will be more than the future value. Time value can be described with the simplified phrase, "A dollar today is worth more than a dollar tomorrow". Here, 'worth more' means that its value is greater. A dollar today is worth more than a dollar tomorrow because the dollar can be invested and earn a day's worth of interest, making the total accumulate to a value more than a dollar by tomorrow. Interest can be compared to rent. Just as rent is paid to a landlord by a tenant without the ownership of the asset being transferred, interest is paid to a lender by a borrower who gains access to the money for a time before paying it back. By letting the borrower have access to the money, the lender has sacrificed the exchange value of this money, and is compensated for it in the form of interest. The initial amount of the borrowed funds is less than the total amount of money paid to the lender.

The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital. Importantly, it is dictated by the external market and not by management. The WACC represents the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere.

Adjusted present value (APV) is a valuation method introduced in 1974 by Stewart Myers.

A swap is defined as a derivative in which two counterparties exchange cash flows and liabilities of one party's financial instrument for those of the other party's. The benefits in question depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest (coupon) payments associated with such bonds. Specifically, two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash flows are to be paid and the way they are accrued and calculated. Usually at the time when the contract is initiated, at least one of these series of cash flows is determined by an uncertain variable such as a floating interest rate, foreign exchange rate, equity price, or commodity price.

Rational pricing is the assumption in financial economics that asset prices will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away". This assumption is useful in pricing fixed income securities, particularly bonds, and is fundamental to the pricing of derivative instruments.

Bond valuation is the determination of the fair price of a bond. As with any security or capital investment, the theoretical fair value of a bond is the present value of the stream of cash flows it is expected to generate. Hence, the value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate.

Return on capital (ROC), or return on invested capital (ROIC), is a ratio used in finance, valuation and accounting, as a measure of the profitability and value-creating potential of companies relative to the amount of capital invested by shareholders and other debtholders. It indicates how effective a company is at turning capital into profits.

The modified internal rate of return (MIRR) is a financial measure of an investment's attractiveness. It is used in capital budgeting to rank alternative investments of equal size. As the name implies, MIRR is a modification of the internal rate of return (IRR) and as such aims to resolve some problems with the IRR.

Valuation using discounted cash flows is a method of estimating the current value of a company based on projected future cash flows adjusted for the time value of money. The cash flows are made up of the cash flows within the forecast period together with a continuing or terminal value that represents the cash flow stream after the forecast period. In several contexts, DCF valuation is referred to as the "income approach".

In finance, rNPV or eNPV is a method to value risky future cash flows. rNPV is the standard valuation method in the drug development industry, where sufficient data exists to estimate success rates for all R&D phases. A similar technique is used in the probability model of credit default swap (CDS) valuation.

Credit valuation adjustment (CVA) is the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of a counterparty’s default. In other words, CVA is the market value of counterparty credit risk. This price depends on counterparty credit spreads as well as on the market risk factors that drive derivatives’ values and, therefore, exposure. CVA is one of a family of related valuation adjustments, collectively xVA; for further context here see Financial economics #Derivative pricing.

The Penalized Present Value (PPV) is a method of capital budgeting under risk developed by Fernando Gómez-Bezares in the 1980s.

The Datar–Mathews method is a method for real options valuation. The method provides an easy way to determine the real option value of a project simply by using the average of positive outcomes for the project. The method can be understood as an extension of the net present value (NPV) multi-scenario Monte Carlo model with an adjustment for risk aversion and economic decision-making. The method uses information that arises naturally in a standard discounted cash flow (DCF), or NPV, project financial valuation. It was created in 2000 by Professor Vinay Datar, Seattle University, and Scott H. Mathews, Technical Fellow, The Boeing Company.

Dividend policy is concerned with financial policies regarding paying cash dividend in the present or paying an increased dividend at a later stage. Whether to issue dividends, and what amount, is determined mainly on the basis of the company's unappropriated profit and influenced by the company's long-term earning power. When cash surplus exists and is not needed by the firm, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program.

Corporate finance is an area of finance that deals with sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value. Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.

## References

1. Lin, Grier C. I.; Nagalingam, Sev V. (2000). CIM justification and optimisation. London: Taylor & Francis. p. 36. ISBN   0-7484-0858-4.
2. Berk, DeMarzo, and Stangeland, p. 94.
3. erk, DeMarzo, and Stangeland, p. 64.
4. Khan, M.Y. (1993). Theory & Problems in Financial Management. Boston: McGraw Hill Higher Education. ISBN   978-0-07-463683-1.
5. Baker, Samuel L. (2000). "Perils of the Internal Rate of Return" . Retrieved January 12, 2007.
6. Grubbström, Robert W. (1967). "On the Application of the Laplace Transform to Certain Economic Problems". Management Science. 13 (7): 558–567. doi:10.1287/mnsc.13.7.558. hdl:10338.dmlcz/103379.
7. Steven Buser: LaPlace Transforms as Present Value Rules: A Note, The Journal of Finance, Vol. 41, No. 1, March, 1986, pp. 243–247.
8. Karl Marx, Capital, Volume 3, 1909 edition, p. 548
9. Bichler, Shimshon; Nitzan, Jonathan (July 2010), Systemic Fear, Modern Finance and the Future of Capitalism (PDF), Jerusalem and Montreal, pp. 8–11 (for discussion of history of use of NPV as "capitalisation")
10. Nitzan, Jonathan; Bichler, Shimshon (2009), Capital as Power. A Study of Order and Creorder., RIPE Series in Global Political Economy, New York and London: Routledge