Wednesday, 28 May 2014

How to understand and use NPV in a business case

As mentioned in the previous posts there are a number of factors (metrics), which need to be accounted for when putting a business case together. One example could be where a corporation has employed you to decide whether to introduce a new product line. Metrics to be included in this calculation include:
  •       Start-up expenditures,
  •       Operational expenditures,
  •       Incoming cash receipts (sales)
  •       Disbursements (Cash paid for materials, supplies, direct labor, maintenance, repairs, and direct overhead) 
  •       Over the life cycle of the product.

The NPV  (Net Present Value) is the forecast financial outcome of a new product initiative. It will enable you to give a fairly accurate forecast on the earning potential. Calculating it will firstly tell the business if the product initiative will return a benefit to the business relative to the cost of financing the investment, and secondly the NPV provides a standard yardstick by which to measure one initiative against another. However, there are many variables in the forecast such as the price of employing people to make the product or inflation rates.

The concept is based on the way that the value of money changes over time.

For example, lets say that I have been asked to choose between being given either:

Option 1 – $1000 today
Option 2 – $1100 in 2 years

At first glance it looks like Option 2 is a better deal because I will get more cash in the hand. But I also need to consider what the value of Options 1s $1000 will be in 2 years. This will depend on the interest rate applied to it.

Assuming an interest rate of 5% pa the $1000 will be worth $1050 ($1000*1.05=$1050) after 1 year and $1102.50 after 2 years ($1050*1.05=$1102.50).

So in this case the FUTURE VALUE of Option 1 is $1102.50 versus Option 2s $1100 if we wait for 2 years. So, I am better to select Option 1 $1000.

The NPV does this calculation in reverse. Instead of calculating the FUTURE VALUE of today’s money it converts all current and future revenue and costs into PRESENT VALUE. Again using the example above, the PRESENT VALUE of Option 1 is $1000, and PRESENT VALUE of Option 2 is $997.73. In addition to the monetary values being entered we also need the rate (called the Discount Rate) to be used and the number of years (or periods) to be calculated.

Step 1: Determine the expected cash flows associated with the project or investment.

Assume that the widget machine would cost $100 (although these numbers will work equally well expressed in other currencies). You expect that implementing the widget machine will bring in an additional $50 the first year, $40 the second year, and $30 the third year (the law of diminishing marginal returns). After 3 years, you expect that the juicer will need to be discarded. So, your expected cash flows are: -$100 right now, +$50 in year 1, +$40 in year 2, and +$30 in year 3. It is a good idea to diagram these cash flows on a piece of paper.

Step 2: Determine the appropriate discount rate. 

This step is crucial to a good analysis, and also requires the most discretion. The discount rate is a number used to convert the values of the expected future cash flows into their present values. This is necessary because of what is known as the "time value of money."

The value of money depends on when it is expected to be paid.
  • For example, you should generally prefer to receive $100 right now than to receive $100 3 years from now. This is because you could have been investing that $100 over those 3 years, and at the end of that period, you would likely have more than your original $100. Therefore, $100 expected in 3 years is actually worth less than $100 right now. All future cash flows must be discounted back to their equivalent present values.

  • Determining the appropriate discount rate requires some consideration; in corporate finance, a firm's weighted-average cost of capital is often used. In the lemonade stand example, you might decide that if you didn't purchase the widget machine, you would probably invest the money in the stock market, where you feel confident you could earn 4% annually on your money. So, 4% is the appropriate discount rate.

Step 3: Discount all the cash flows and calculate NPV.

This is done using a simple formula: P / (1 + i)^t, where P is the amount of the cash flow, i is the discount rate, and t represents time. Cash flows that occur immediately do not need to be discounted, as they are already expressed as present value. Using a 4% discount rate, you can get the output of the NPV.

Step 4: Decide if the project is profitable enough.

NPV is an indicator of how much value an investment or project adds to the firm. With a particular project, if NPV given is a positive value, the project is in the status of positive cash inflow in the time of t (usually your chosen year 0).

If NPV is a negative value, the project is in the status of discounted cash outflow in the time of t. Appropriately risked projects with a positive NPV could be accepted.

In financial theory, if there is a choice between two mutually exclusive alternatives, the one yielding the higher NPV should be selected.

It means...
NPV > 0
the investment would add value to the firm
the project may be accepted
NPV < 0
the investment would subtract value from the firm
the project should be rejected
NPV = 0
the investment would neither gain nor lose value for the firm
We should be indifferent in the decision whether to accept or reject the project. This project adds no monetary value. Decision should be based on other criteria, e.g., strategic positioning or other factors not explicitly included in the calculation.

NPV Excel Spreadsheet Download Link Here

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