• Home
  • Finance
    • Financial Management
    • Strategic Management
    • Investment Analysis and Portfolio Management
    • Project Management
    • Islamic Banking & Finance
    • Auditing
  • Marketing
    • Principle of Marketing
    • Marketing Management
    • International Marketing
    • Advertising & Promotion
    • Commercial Challenges
  • HRM
    • Human Resource Management
    • Principles of Management
    • Training & Development
    • Employee Performance Management
  • Others
    • Introduction to Business
    • Business Communication
    • Banking & Finance
    • Entrepreneurship
    • Economics
  • Personal Skills
  • Tips & Tricks
  • About Us
    • Contact US

Business Study Notes

B.Com, M.Com. BBA & MBA Exam Study Online

  • Home
  • Finance
    • Financial Management
    • Strategic Management
    • Investment Analysis and Portfolio Management
    • Project Management
    • Islamic Banking & Finance
    • Auditing
  • Marketing
    • Principle of Marketing
    • Marketing Management
    • International Marketing
    • Advertising & Promotion
    • Commercial Challenges
  • HRM
    • Human Resource Management
    • Principles of Management
    • Training & Development
    • Employee Performance Management
  • Others
    • Introduction to Business
    • Business Communication
    • Banking & Finance
    • Entrepreneurship
    • Economics
  • Personal Skills
  • Tips & Tricks
  • About Us
    • Contact US
Home » Net Present Value (NPV)

Net Present Value (NPV)

By Richard Daniels Reading Time: 5 mins
Updated August 4, 2022

Before going into the details of Net Present Value (NPV) and Internal Rate of Return (IRR), a few of the basic concepts are important to know.

Present Value

The present value is an important concept of Financial Management. It is concerned with the present value of cash flows that are taking place in some future. In short, the apples are compared with apples. This means that all the cash flows taking place at different time intervals must be compared at one point in time in order to determine their present value.

For example, if one has $ 100 in his hand and after ten years he may also possess $ 100. As both amounts are equal but their actual value is different, which means that the present value of today’s $ 100 is more than the ten years after $100.

Discounting

To bring the future cash flow back to the present is called discounting. In order to compare the two cash flows taking place at different time intervals, first of all, both of these should be discounted back at some common present time. For this purpose, there should be some interest rate (opportunity cost) that helps in the discounting process.

Net Present Value (NPV)

Net present value is the most important concept and technique in the Capital Budgeting area of financial management. All the future cash flows are discounted back at the present and subtracted from the initial investment to give the value of net present value. If one wants to start a new project then how can he measure the feasibility and profitability of that project?

The simple and effective way is through net present value calculation. In net present value calculation, all the expected cash flows are forecasted and discounted with a certain discount rate or interest rate. If the net present value of a project is more than zero then that project is favorable for the investor. The formula for net present value is given below.

Net Present Value Formula

Net Present Value = -Io+∑CFt  / (1+i)t

In the above equation “Io” means the initial investment that is in the shape of cash outflow.

“CFt” are the cash flows that are occurring at different time intervals.

“i” is the interest rate.

“t” is the year in which cash flow occurs.

Although, the net present value is a very powerful technique of capital budgeting, still has certain drawbacks. The main reason is that the cash flows are the estimated values that are not actually real, also the discount rate is determined subjectively. But, still, net present value is used frequently in financial management in ascertaining the value of any investment or even the whole company. Moreover, if there are more than 2 or 3 projects available to invest in, then the project that has a higher net present value is the better one.

Example

Suppose David wants to start a retail store in a certain market. He makes an initial investment of $ 200,000, the revenue of the first year is $ 12,000 per month and the second year is $ 18,000 per month. The discount rate is based on the expected rate of return that your business must generate.

Suppose the discount rate is 10%, so if the new retail store returns him less than the discount rate then it is not feasible for him to invest in that business as he can easily earn a 10% return by putting his amount into the bank. Now David needs to know whether this new project is feasible for him or not. For this purpose, he needs to calculate the NPV of the project.

Solution

Initial Investment = Io = $ 200,000

Cash inflow in the first year = CF1= 144,000

Cash inflow in the second year = CF2= 216,000

Putting values in the formula of NPV

NPV = -Io+CF1 / (1+i)1 + CF2 / (1+i)2

NPV = -200,000 + 144,000 / (1.1) + 216,000 / (1.1)2

= -200,000 + 130,909 + 178,512

As the answer of net present value is more than zero.

NPV = 109,421

So, this project of starting a new retail store is favorable for David.

Net-Present-Value-graph

Internal Rate of Return (IRR)

Another important technique of capital budgeting is the Internal Rate of Return (IRR). It is similar in the calculation to the net present value, but IRR is expressed in percentages. Due to this fact it can be compared with the other interest rates, cost of capital and inflation rate, etc.

Another feature of IRR is that it remains constant throughout the life of the project. This means the IRR for the first year of a project is the same for the second year and so on. IRR is actually the break-even point of the project. At this rate, the project returns all the initial investment throughout its life.

The formula of IRR is similar to NPV, but there is a small difference in its calculation. The equation of NPV is used for the determination of IRR, but in that equation, the value of NPV is considered to be zero. After keeping the NPV equal to zero, the value of “i” is determined to give the value of IRR, because IRR is actually a rate of return on the investment. In simple words, the IRR is that value of “i” at which the NPV value is equal to zero.

More From Business Study Notes:- Capital Budgeting

In the calculation of IRR, the Trial and Error method or iteration method is used because it is much effort and time-consuming to solve the higher degree polynomial equations. In a trial and error method the value of “i” is set to make the equation equal to zero. Mostly the calculation demands more than one try. So if the equation does not result in a zero answer, another value of “i” is set and again the calculation is made to get the answer equal to zero. This process repeats a number of times unless the equation becomes zero. The rate of “i” at which the equation becomes zero gives the IRR.

There is a big difference between the “i” of the NPV and the “i” of the IRR equation. The “i” in the NPV is the external required rate of return based on the opportunity cost of capital that must be desired by an investor in investing in any new project. This required rate of return comes from the risk-free rate of return given by the banks on the deposited money. On the other hand, the “i” in the IRR equation is the forecasted rate of return that comes from the expected cash flows of the project, so the “i” is not set externally.

Example

Considering the above NPV example, David has to find the value of IRR for his new retail store project. The other data is the same.

Solution

By using the formula of IRR

NPV = 0 = -Io+CF1 / (1+i)1 + CF2 / (1+i)2

By keeping the value of “i” at 10%, the answer of the equation becomes 109421, which is much higher than zero. So the rate of “i” is increased to 15%. Then

NPV = 0 = -Io+CF1 / (1+0.15)1 + CF2 / (1+0.15)2

NPV = 0 = 88,544

This answer is again much higher than zero. If “i” is set to 45% then the answer becomes 2045 which is slightly above zero. So by keeping the “i” equal to 46% the equation gives approximately zero answers. So the IRR is 46% based on the future cash flows of the new project.

Author at Business Study Notes
Richard DanielsAuthor at Business Study Notes

Hello everyone! This is Richard Daniels, a full-time passionate researcher & blogger. He holds a Ph.D. degree in Economics. He loves to write about economics, e-commerce, and business-related topics for students to assist them in their studies. That's the sole purpose of Business Study Notes.
Love my efforts? Don't forget to share this blog.

Related Posts:

  • What Is The Modified Internal Rate of Return Analysis?
    What Is The Modified Internal Rate of Return Analysis?
  • Capital Budgeting Techniques and Examples
    Capital Budgeting Techniques and Examples
  • What Is Capital Rationing? Give Example and Reason to Choose
    What Is Capital Rationing? Give Example and Reason to Choose
  • What Are The Types Of Project Selection Models?
    What Are The Types Of Project Selection Models?
  • What is the Process of Motivation? Explain in detail
    What is the Process of Motivation? Explain in detail

Filed Under: Finance, Financial Management Tagged With: Define Net present value, Internal Rate of Return Farmula, net present value example, Net Present Value Farmula, net present value formula

Related Posts

System-Views-of-Management-image

System Views of Management

System Views System views of management associates with the Management division of the organization and it assumes that all of the organizations are … [Read More...]

Leadership Theories

Situational Leadership Theories

Situational Leadership Theories Situational model of leadership is a factor that emphasizes the behavior of the leaders regarding different situations. … [Read More...]

Behavioral Leadership Model

Behavioral Leadership Model

Leadership  Leadership is the most critical and complex responsibility across any organization. It is because the leadership requires to be realistic, … [Read More...]

career development process in hrm

Career Development Process

Career Development Process Today's career development process has become a threat for students, especially a question that may stun many students who have … [Read More...]

Strategic leadership

Strategic Leadership Model

Strategic Leadership Model The strategic leadership model is basically the study of the leadership style. It describes the ways of modernizing an … [Read More...]

Types of Managerial Decision Making

Types of Managerial Decision Making

Managerial Decision Making Decision Making is an art of selection of one feasible alternative decision from many. Therefore types of managerial decision … [Read More...]

Quantitative-management-approach

Quantitative Management Approach

Quantitative Management Approach The quantitative management approach is used to enhance decision making power by using quantitative tools. As well as … [Read More...]

Effective-business-messages-image

Effective Business Messages

Effective Business Messages The process through which business messages are effectively prepared that have the potential to create desired results from … [Read More...]

Search the Site

ADVERTISEMENT

Business Study Notes

Business Study Notes is all about business studies or business education. Visit us to find here free business notes of all the subjects of B.com, M.com, BBA & MBA online.

Disclaimer

All the images and videos present on the Business Study Notes are not owned by us, if you found anything under copyrights, please Contact Us, we will remove it ASAP.

Categories

© Copyright 2023 Business Study Notes. All rights reserved. Privacy Policy, Sitemap.  
DMCA
PROTECTED