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Net present value is the present value of net cash inflows generated by a project including salvage
value, if any, less the initial investment on the project. It is one of the most reliable measures used
in capital budgeting because it accounts fortime value of money by using discounted cash inflows.
Before calculating NPV, a target rate of return is set which is used to discount the net cash inflows
from a project. Net cash inflow equals total cash inflow during a period less the expenses directly
incurred on generating the cash inflow.
NPV = R
Initial Investment
R1
(1 + i)1
R2
(1 + i)2
R3
(1 + i)3
+ ...
Initial Investment
Where,
i is the target rate of return per period;
R1 is the net cash inflow during the first period;
R2 is the net cash inflow during the second period;
R3 is the net cash inflow during the third period, and so on ...
Decision Rule
Accept the project only if its NPV is positive or zero. Reject the project having negative NPV. While
comparing two or more exclusive projects having positive NPVs, accept the one with highest NPV.
Examples
Example 1: Even Cash Inflows: Calculate the net present value of a project which requires an
initial investment of $243,000 and it is expected to generate a cash inflow of $50,000 each month
for 12 months. Assume that the salvage value of the project is zero. The target rate of return is
12% per annum.
Solution
We have,
Initial Investment = $243,000
Net Cash Inflow per Period = $50,000
Number of Periods = 12
Discount Rate per Period = 12% 12 = 1%
Net Present Value
= $50,000 (1 (1 + 1%)^-12) 1% $243,000
= $50,000 (1 1.01^-12) 0.01 $243,000
$50,000 (1 0.887449) 0.01 $243,000
$50,000 0.112551 0.01 $243,000
$50,000 11.2551 $243,000
$562,754 $243,000
$319,754
Example 2: Uneven Cash Inflows: An initial investment on plant and machinery of $8,320
thousand is expected to generate cash inflows of $3,411 thousand, $4,070 thousand, $5,824
thousand and $2,065 thousand at the end of first, second, third and fourth year respectively. At the
end of the fourth year, the machinery will be sold for $900 thousand. Calculate the present value of
the investment if the discount rate is 18%. Round your answer to nearest thousand dollars.
Solution
PV Factors:
Year 1 = 1 (1 + 18%)^1 0.8475
Year 2 = 1 (1 + 18%)^2 0.7182
Year 3 = 1 (1 + 18%)^3 0.6086
Year 4 = 1 (1 + 18%)^4 0.5158
The rest of the problem can be solved more efficiently in table format as show below:
Year
$3,411
$4,070
$5,824
$2,065
Salvage Value
900
$3,411
$4,070
$5,824
$2,965
0.8475
0.7182
0.6086
0.5158
$2,890.68
$2,923.01
$3,544.67
$1,529.31
$10,888
Initial Investment
8,320
$2,568
thousand
Disadvantage: It is based on estimated future cash flows of the project and estimates may be far
from actual results.