In modern economic terminology, quite often you can find such a term as “net present value”, which means the estimated value that is used when comparing various investment options.
One of the most important and widespread decisions made by business entities is the issue of investments in other enterprises. So, every year millions of rubles are invested in factories or their equipment, which will operate and bring additional profit for many decades. The future cash flow that investment can bring is often somewhat uncertain. And if factories or factories are already built and do not bring the expected profit, then the investor will no longer be able to dismantle and resell them in order to compensate for the investment. In this case, the business entity (investor) incurs irrecoverable losses.
Terminology
Net present value characterizes the current amount of cash resources needed to obtain future income equivalent to its counterpart received from the implementation of a specific investment project. For example, there is a deposit rate of 10%, then 100 rubles will bring 110 rubles at the end of the year. From the point of view of cost-effectiveness analysis of a contribution of 100 rubles to a deposit or to an investment project that can bring the same 110 rubles, the present value will be the same.
There is also an index of profitability of an investment project - this is the result of dividing the net present value by the total amount of discounted investments (investment costs).
Determining the feasibility of investments
When accepting an investment project for more than one year, the benefit from such investments can be determined by bringing the future funds received at the end of the year to the start date of the project. This determines the net present value, which should "return" to the investor. This amount is compared with projected costs, however, when conducting such an assessment, it is necessary to take into account the "pitfall" in the form of interest capitalization. That is, dividends are paid to the investor once at the end of the year, but the bank can pay interest on a monthly basis. That is why the net present value when conducting a comparative analysis is determined by different formulas, and in the case of a financial institution, it is necessary to take into account the monthly capitalization of interest on a deposit.
In the economic literature one can also find such an “academic” formulation: the net present value of the investment project is the positive balance of financial resources received by all cash receipts and expenses. Its amount is reduced to the initial time moment (the start date of the investment project).
The result obtained reflects the amount of money that the investor can receive after the implementation of the project. Often, the current value reflects the total profit of the investor, but in this case, the residual value of the project itself should not be taken into account.
Net present value of the project: calculation formula
So, when calculating this indicator, the following formulas are used:
- NPV = AMOUNT (CF t / (1 + i) t);
- NPV = -IC + AMOUNT (CF t / (1 + i) t),
Where:
t is the number of years;
CF - payment through t-years;
IC - invested capital;
i is the discount rate.
Discount factors
Net present value can be reliably determined only if the discount rate is correctly selected. Based on the value of this indicator, you can find the corresponding coefficients for the period for which the analysis is carried out.
Only by determining the value of the receipts and expenses of cash flows, the net present value can be determined as the difference between these two values. As a result, this indicator can be both positive and negative.
Let us dwell on its values:
- a positive value will show that in the billing period, cash receipts in discount terms will exceed the same amount of investments, and this helps to increase the value of the business entity;
- a negative value indicates the absence of the desired rate of return, which leads to certain losses.
Considering Alternative Investment Options
Often, investors before investing their own funds in a particular project ask themselves the question: what discount rate should the company use when calculating the net present value? The answer depends on the availability of alternative investment opportunities. For example, sometimes, instead of a certain investment option, an enterprise uses its financial resources to acquire a different type of capital that can bring big profits. Or a business entity acquires bonds, which are characterized by guaranteed availability of their own profitability.
