The Net Present Value, abbreviated as NPV, is a very important and significant concept in finance, commercial real estate, and project evaluation. The basic underline of NPV is to evaluate that a project is worth undertaking if the return outweighs the costs. The concept itself aligns with the parameters of the time value of money or time series. Time series is a statistical technique that deals with time series data, or trend analysis.
What is NPV?
NPV is a technique or investment measure that conveys to the investor whether the investment is achieving a target return on a given initial investment.
The NPV is the sum of the present values of all the expected incremental cash flows. The discount rate used is the firm’s cost of capital, adjusted for the risk level of the project. It is, therefore, necessary to discount the future returns back to today and then compare this present value to the costs to determine whether a project should be undertaken or not.
A positive NPV project is expected to increase shareholder’s wealth; a negative NPV project is expected to decrease it, and a zero NPV project has no expected effect on shareholder’s wealth. For Independent projects, the NPV decision rule is simply to accept any project with a positive NPV and to reject any project with a negative NPV.
A key advantage of NPV is that it is a direct measure of the expected increase in the enterprise value of the firm.
NPV does not include any consideration of the size of the project. For example, an NPV of INR 100 is great for a project costing INR 100 but not so great when the cost is INR 1 million.
How to Calculate NPV
- Determine your initial investment
- Determine a time period to analyze
- Estimate your cash inflow(how much money you make) during each time period
- Determine the appropriate discount rate
- Discount your cash inflows
- Sum your discounted cash inflows and subtract your initial investment
What is IRR?
IRR is a financial metric for cash flow analysis, primarily for evaluating investments, capital acquisitions, proposals, and business case scenarios. IRR analysis begins with a cash flow stream, it is the discount rate that makes the present value of the incremental cash inflow expected after tax deductions just equal to the initial cost of the project. More generally, the IRR is the discount rate that makes the present values of a project’s estimated cash inflow equal to the present value of the project’s estimated cash outflows, or that discount rate which makes the NPV equal to zero.
If IRR is greater than the required rate of return, the project can be accepted, and if IRR is less than the required rate of return, it can be rejected.
To calculate IRR, just calculate the discount rate by taking NPV as zero in the above formula for NPV.
IRR measures profitability as a percentage, showing the return on each rupee invested.
It provides information on the margin of safety that the NPV does not. From the calculated IRR, one could easily tell how much below the IRR return the actual return could fall.
The disadvantage of the IRR technique is the possibility of producing rankings of mutually exclusive projects different from those of NPV analysis and the possibility that a project can have multiple IRRs or no IRR.
NPV technique should always be used if NPV and IRR give conflicting decisions, if IRR is less than the cost of capital, the result will always lead to negative NPV. As a rule of thumb, while evaluating two projects always select the project with highest NPV.