This is the modern method of evaluating investment proposal. Net Present Value (NPV) is defined as the excess of present value of project cash inflows over that of outflows. The cash flows of a project are discounted at some desired rate of return which is equivalent to the cost of capital. This method recognizes the fact that the amount earned today is worth more than in the same time tomorrow. The Relation between the Present Value and the Future Value of an amount is given by the below formula.
Advantages of NPV Method
- It recognizes the time value of money and considers all cash flows over the entire economic life of the project
- It considers all cash flows over the entire life span of the project in the calculation of profitability
- This method is employed in selecting mutually exclusive projects
- It is consistent with the objective of maximizing the wealth of the shareholders of the company
Disadvantages of NPV Method
- This method is too difficult to understand as compared to payback period method
- This method does not provide satisfactory solution when the projects compared involving different amounts of investment
- Profitability is not related to the capital outlay required for the project
For two or more projects, the project with highest NPV is selected. Let us now see how to evaluate project proposals using MS Excel (R).
There are three projects A, B and C. The Cash Inflow and Cash Outflow for next 10 years is given below. The interest rate for each of the project is taken as 10%.
The Net Present Value using the NPV Excel Function is calculated below.
Note that the NPV for Project C is higher among all the projects, hence it can be selected. It is to be noted that if the cash inflows are steady and increasing every year, the NPV will be higher. If there is erratic inflow of cash flows (as in the case of Projects A and B, the NPV will be less even though there is more cash inflow in the initial years.
One can also calculate the projects with different interest rates. It is shown below.
It is to be noted in the above calculation that the interest rate for Project A is 12%, Project B is 13% and Project C is 15%. For Project B, the NPV is negative (Red Colour) and hence it has to be completely discarded (NPV should always be Positive).