Business
Positive NPV
Positive NPV, or Net Present Value, indicates that an investment or project is expected to generate more cash inflows than outflows over time. It is a key financial metric used to evaluate the profitability of an investment by discounting future cash flows to their present value. A positive NPV suggests that the investment is expected to add value to the business.
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8 Key excerpts on "Positive NPV"
eBook - ePub- Brümmer LM, Hall JH, Du Toit E(Authors)
- 2017(Publication Date)
- Van Schaik Publishers(Publisher)
We all know that, provided income exceeds cost, a profit will be shown. If income is lower than cost, a loss will result. The criterion here, therefore, is whether the total present value of all future cash inflows will be greater than the initial cost of the investment. If the total present value of a series of cash inflows is greater than the initial cost of the investment project, a profit will be shown and the investment should be accepted as a feasible proposition. If the total present value of these inflows is less than the initial cost, a loss will be sustained and the project should be rejected.The term “net” means that a difference must be found. In terms of the NPV concept, the difference that we must find is the one between the total present value of a series of future cash inflows and the cost of the initial investment. If the net amount, more commonly and simply referred to as the NPV, has a positive value, the investment may be accepted. If the NPV is a negative figure, the project should be rejected.An explanation of cash flows
Before discussing an example of the NPV, we should gain a fuller understanding of the meaning of cash inflows and outflows. A cash inflow, as the name implies, is cash flowing into the organisation. Similarly, a cash outflow is cash flowing out of it.
- Daniel Adrian Doss, William H. Sumrall III, Don W. Jones(Authors)
- 2017(Publication Date)
- Routledge(Publisher)
Some initiatives may require periods that are longer than those that are considered within this text. When these situations occur, it is recommended that NPV calculations be performed through the use of software spreadsheets, proprietary software, or financial calculators. Also, within the context of collegiate finance courses, a tabular solution is also available to solve NPV problems involving a variety of periods. However, for the purposes of this text, the use of the basic formula is appropriate to demonstrate the basic concept of net present value and to delineate the calculations through which NPV problems are solved. Future editions of this text, if any, are anticipated to contain the tabular solution methods of NPV problems.6.8 Chapter Comments and Summary
This chapter introduced the net present value (NPV) method of capital budgeting. The methods of capital budgeting encompass perspectives of time, cash value, rate, and profitability potential. The NPV is indicative of a cash perspective regarding the rendering of capital budgeting decisions. Further, the NPV method incorporates the time value of money within its primary construct. Derivation of the NPV method can occur through algebraic manipulation of the current monetary value formula given in Chapter 4 .The NPV method involves a consideration of the anticipated cash flows of a capital investment through time. These anticipated future values are discounted to determine their current monetary equivalencies. Conceptually, the NPV is the sum of the present monetary value of the anticipated future cash flows of a potential capital investment excluding the costs of investment. Therefore, the NPV method provides a cash-based perspective regarding capital budgeting initiatives. The NPV may be used as a solitary method of capital budgeting or may be used in conjunction with any (or all) of the capital budgeting methods described within this text. The NPV method may be used to examine single capital initiatives or multiple capital initiatives. Further, this method may be used with or without the constraints imposed by mutual exclusion conditions.
- Ivan E Brick(Author)
- 2017(Publication Date)
- WSPC(Publisher)
< 0.∑ is the Greek letter sigma. In mathematics it represents summation. The subscript letter t in CFt is a time index. The T = 1 below the sigma and N above the sigma implies that you are summing the present value of the cash flows from period 1 to n. Hence, the above equation is telling us to do the following mathematical operations:Fortunately, we can use the NPV function in excel to find the Net Present Value. Before, we do an example, let us give an economic interpretation for Equation (5.2) which is the second term of the right-hand side of Equation (5.1). In a nutshell, expression (5.2) represents the market value of the asset. For a given interest rate, it represents the maximum price you would pay for the asset. If the market value of the asset is greater than the initial investment, I, then you have yourself a great deal, the NPV is positive and you would accept the project. If you accept the project and the market believes in the firm’s projections, then the stock price should increase to reflect the Positive NPV. On the other hand, if the market value of the asset is less than I, then the asking price is too high, NPV is negative and you would recommend rejection of the project. Should you accept the project, the stock price should fall!Interestingly, back in the 1980s, academic research found that whenever oil companies announced major exploration in the continental US, the stock price of that oil company declined at the time of the announcement. What was the stock market telling the managers of the firm? They were saying that given current oil prices and technology for oil extrapolation, these projects had a negative NPV.Let us do a more concrete example. As an assistant to Mr. Richard Wagoner, CEO of General Motors, you have been asked to analyze a potential new automobile model, Andromeda, and the staff has provided some key estimates. The amount of money GM will have to invest to launch the new brand is $450 million. The marketing staff estimates that the demand is fairly robust, projecting sales of 30,000 cars next year, 45,000 in the following 3 years, 30,000 in year 5 and no more sales thereafter. You estimate a profit of $5,000 per car sold. Mr. Frederick Henderson, Vice Chairman and Chief Financial Officer, tells you that GM’s cost of funds is 11%. You must make a presentation to both men in 20 minutes. What do you recommend? First thing is that you do not panic. Your job may depend on this presentation, but you still have your health.
eBook - ePub- P. Cassimatis(Author)
- 2013(Publication Date)
- Routledge(Publisher)
For the $100,000 project with $30,000 annual cash flows over 5 years, the NPV was found to be $13,724 and the IRR 15.2%. By plotting those two points to scale, a smooth curve can be fitted that shows the relationship of NPV to the discount rate. Therefore, as long as the cost of capital is less than the IRR (15.2%) the project has a Positive NPV. If the cost of capital is greater than the IRR, the NPV is negative and the project should be rejected.4.3 Profitability index
In evaluating a capital project, one might ask what is the relationship of benefits to the cost of such an undertaking. The answer to this practical question is provided by the profitability index, or benefit-cost ratio, and it is mathematically expressed aswhere the numerator is the present value of the project's cash flows discounted by the firm's cost of capital, and C 0 is the present value of the total investment. As long as the profitability index is greater than 1.0 the project is acceptable.Consider the investment in Section 4.1 , where the initial outlay is $100,000 and the expected cash flows are $30,000 annually over 5 years. The cost of capital is 10%. The profitability index (PI) is computed as follows:Notice that a PI greater than 1.0 also implies a Positive NPV. Therefore, for any given project, the profitability index method and the net present value method give the same result. When we must choose between two or more investments, the PI can be misleading and we must use the NPV method instead. Suppose a firm can select one of the following two projects:Both projects are profitable, but A has a higher profitability index and B has the higher net present value. A disadvantage of the PI method is that it measures the relative profitability of a project, whereas the net present value expresses the economic benefits of the project in absolute terms. Therefore, if we calculate the incremental benefits of project B based on the incremental cost of the project, we obtain the following profitability index:
eBook - ePub- Keith Ward(Author)
- 2013(Publication Date)
- Routledge(Publisher)
However, money has a time value and if we are to make sensible decisions we need to incorporate the real value of future cash flows into our evaluation criteria. We can achieve this by applying discount rates to all future cash flows so that we bring them back to their equivalent present value, which makes all the project cash flows directly comparable. The most common way of doing this is to select a discount rate for the company and to apply this to all the cash flows of the project. A positive net present value indicates that the financial return from the investment is acceptable, but the opportunity costs evaluation against other potential investments must still be done. This requires comparison of what benefits could be achieved by investing in a different mix of projects and where there are constraints on the total amount of capital which can be invested, this comparison is very important. In such a situation of capital rationing, the profitability index can be used to compare relative investment returns between projects; this is done by dividing the present value of the net inflows by the value of the initial investment.Table 7.25 Comparison of internal rate of return (IRR) and accounting return on investmentSeveral major investment evaluation techniques are used by companies: 1 payback period; 2 discounted payback period; 3 Discounted cash flow (a) net present value (NPV) (b) internal rate of return (IRR); 4 Accounting return on investment (ARR).These provide different views of any project and no single criterion can be regarded as giving the answer, so many companies use a combination of techniques and adjust the results to allow for the relative risk of the investment being examined.AppendixNew car example using financial statements comparison ResuméOur sales and marketing director’s car cost £21 000 and is assumed to have a £6000 residual value at the end of three years. A fuel efficiency device becomes available for £4500 with projected savings of £2000 per year.
eBook - ePub- Mark P. Holtzman, Sandy Hood(Authors)
- 2013(Publication Date)
- For Dummies(Publisher)
Table 11-6 .You follow the same process as for the house extension in ‘Homing in on NPV and decision-making’, earlier in this chapter. As the NPV for Paul is positive we recommend that he should go ahead. The split-second when he decides to go ahead will then add £76,546 to the value of his business.Working that NPVAfter you’ve calculated the NPV – by finding the annual cash flows and listing net cash flow on a year by year basis, discounting these cash flows to produce a present value for each annual cash flow and adding up all the cash flows to find the net cash flow – you may be wondering about how to use it.Well, you don’t need a company policy. Although the payback method tells you the time needed to pay back your investment, you can go ahead only if that payback period was shorter than the company policy period. But the NPV provides an absolute decision. If the NPV is a positive value it increases the value of the business; if it’s negative it reduces the value of the business. So say yes to Positive NPVs, they’re worth the investment!Putting Payback and NPV into PracticeWe have a good look at the payback and NPV methods in the earlier sections ‘Getting Your Money Back: The Payback Technique ’ and ‘Understanding Time Value of Money and Net Present Value (NPV) ’, respectively, and if you’re itching to practise them yourself (and even if you’re not!), here’s your chance.For AAT exams payback is examined at level 3 and NPV at levels 3 and 4. Typically, AAT questions give candidates most of the information without requiring a lot of calculations for the net cash flows. They always provide the discount rates.Task the first: Payback See how you get on with the following task.The company Macho Machines (‘making mechanisms for real men’) has the opportunity to manufacture a new product that involves an initial capital investment of £380,000. The product has an expected life of three years, and at the end of this period the equipment bought as part of the initial investment will be sold (a disposal) for £60,000. Table 11-7- eBook - ePub
- Alan Parkinson(Author)
- 2012(Publication Date)
- Routledge(Publisher)
Table 7.2 can help to solve a dilemma. If a management team used an undiscounted cash flow assessment, both investments return the same net inflow of £170,000. The same applies to an undiscounted payback assessment with both investments paying back in 2.75 years. When the time value for money is considered however, a discounted NPV cash flow assessment, Investment B is favoured, returning £60,490 as opposed to £58,490 for A. On a discounted payback assessment however, Investment A pays back in 3.6 years, whereas B takes 4.4 years. Clearly, the dilemma facing the management team here is great. It is compounded by the fact that, on an IRR basis, A has a rate of 12.2% and B 11.4%.In ranking situations like this, where funds may be inadequate to finance all potentially profitable projects, or where a choice needs to be made between a number of contenders, a further method of evaluation called the profitability index could be used. This is based on the same data as the NPV method, in that a target rate of return has to be established and the NPV calculated. What then happens is that the present value of an investment’s inflows is related to the present value of its outflows in the form of a ratio, this being:Under this criterion, the two investments would be ranked as follows: The profitability index shows us the net present value of each £ invested. Under this criterion, investment B shows up better than A.It is quite common for the profitability index to be misused. This is because the term cash outflow is often interpreted as relating solely to the initial outlay at time 0. It is not unusual for net outflows to be encountered in subsequent years and these must be incorporated as outflows within the index calculation.In summary, what we can say is that the common aim of discounted cash flow techniques is to translate a projected stream of cash flows into one single index number that is then capable of comparison with other index numbers.If the projected net cash flows are discounted back to present values at a predetermined target rate of return, then the sum of these plus or minus discounted values will be the net present value of the project in absolute terms. If, on the other hand, they are discounted at a rate which results in the sum of the present values of the projected inflows equating exactly with the sum of the present values of the projected outflows, then the net present value will be nil and the rate that needs to be applied in order to achieve this balance is the internal rate of return of the project. This is consequently a relative 
- Martin Hopkinson(Author)
- 2017(Publication Date)
- Routledge(Publisher)
The models for use with this book are relatively simple, partly because simplicity has its merits, but also because many have been designed to focus on particular modelling issues. As simple models, they are captured on single Excel sheets. However, if a model becomes larger, there is often a good case to be made for introducing separate sheets for model documentation, inputs, calculations and outputs. Sometimes, multiple Excel files are used, such that outputs from one part of the model become inputs for another in a different file. In this event, version control becomes particularly important. It is good practice to match output and input formats, to make copying across or the use of hyperlinks easy to follow.Approaches to Modelling Cash Flows
When building an NPV model, a number of decisions will need to be made in respect of the approach to modelling cash flow. One decision is whether or not to enter all inputs as positive numbers and handle net cash flow calculations by subtraction or to enter all direct costs, opportunity costs, disbenefits and deductions to benefits as negative numbers, in which case net cash flows would be calculated by summation. The latter approach is the one illustrated by most financial modelling and accountancy text books. However, the former may be simpler for users to follow, particularly if some components are sourced from other files. For example, if cost inputs are sourced from a project implementation cost model, they will be positive numbers. The models illustrated by this book use positive values for all inputs for this reason.Another decision to be made is to select the duration of periods into which cash flows are divided and calculated. The most common choice is to use annual periods. However, shorter periods may be preferred on the grounds of achieving a more accurate calculation of discounting effects. The case for this becomes stronger for relatively short projects with high discount rates and lumpy cash flows. Against this, it should be borne in mind that discount factor steps are but one of many sources of modelling simplification and that increased accuracy of discounting calculations might create the illusion of a greater degree of certainty than the underlying data can bear. However, if short cash flow periods will, at some point, be required, it is easier to start with a model with shorter periods than to subdivide it into a greater number of periods at a later stage.
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