Net Present Value – NPV

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This is one of the important & most widely accepted discounted cash flow capital budgeting techniques which we generally use for evaluation of projects. NPV may be defined as the sum of present values of cash inflows less the total cash outflows. Present value is calculated by multiplying the cash inflows by discount factor which is further summed up in order to find out total present value of cash inflows. Total initial outflow is then deducted from total present value to arrive at Net present value.  

Discount factor is calculated by formula {1/ (1+r)^n}, where r = discount rate (generally WACC) & n = no. of years.

Calculation Formula
Where,
-C0 = Initial Investment
 C = Cash Inflow
 R = Discount rate
 T = Time 

Example

Decision Rule
Accept the project, if NPV > 0 & Reject if NPV < 0. In above example, NPV > 0 i.e. 41,647. Hence we accept the proposal.

Merits of NPV
1. It considers Time value of money (TVM) which tends to give most accurate picture of the cash flows.
2. It considers the entire cash inflows & outflows.
3. This is based upon cash flows concept rather than accounting profit.

Demerits of NPV
1. Assumptions of Cash Flows are based on estimates: Sometimes estimates might not hold true and 100% accuracy can’t be obtained.
2. Discount rate assumption: This is again very difficult task to predict discount rate with 100% accuracy as nobody can predict mood of lender’s (banks / financial institution). Revision in lending rates at later stage of project can impact NPV a lot.

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