Management and shareholders are mainly concerned for the long term returns over investment. In a stable economy where some degree of certainty prevails companies prefer to invest in long term projects which require heavy investments initially and return is expected after or in many years to come. In a situation where inflation rates are high simple calculation of payback often give deceiving results because it does not consider time value of money. To calculate the exact return one must know the value of one dollar return today to be received after two or three years. The deteriorating value of money poses low value to one dollar after three years than its value today. The question arises how this deteriorating value of money should be dealt in evaluating the viability of long term projects. Various techniques are adopted in this regard like Internal Rate of Return, Profitability Index, and Net Present Value.

[adsense1]Net Present Value is the most superior of all techniques which discounts the expected cash flows over the period of the project by taking into account companies required rate or WACC. This is also called the discounted cash flow technique to the capital budgeting. Though Internal Rate of Return is also a discounted cash flow technique but it has some practical limitations therefore considered inferior to Net Present Value method. With the present value method, all cash flows are discounted to present value using the required rate of return. The Net Present Value of an investment proposal is the present value of all cash inflows over the period of the project less present value of cash out flows. If the resultant figure is zero or less than zero the project is rejected otherwise it is accepted. Another way to express the acceptance criterion is to say that the project will be acceptable if the present value of cash inflows exceeds the present value of cash outflows.

Calculating Net Present Value:

The NPV can be expressed as:[sky]

NPV = ((FV1 / 1+K) + (FV2 / (1+K)2 + (FV3 / (1+K)3 + ———- + (FVn / (1+K)n)) – I0

Where,

I0     =   Investment outlay
FV    =  The future values received in years 1 to n
K      =  The return available on equivalent risk security in the financial market

Example:

A company is evaluating two projects with an expected life three years and investment outlay of $ 1 million. The estimated net cash inflows for each project are as follows:

The opportunity cost of capital for both projects is 10%.

Required: To calculate the NPV

Solution:

The NPV calculation for Project A is: