Using Net Present Value to Measure Return

If your company has not yet used the net present value (NPV) method of measuring the rate of return on a proposed capital investment project, chances are good that it will do so in the near future. During the past several years, NPV has become one of the most commonly used methods of capital investment evaluation.

For a number of reasons, the popularity of the NPV method has grown rapidly. Most important, it recognizes the impact that inflation or high interest rates are likely to have on the worth of a new capital investment. However, even with the cooling of inflation and an accompanying softness in interest rates, the NPV method is likely to retain most, if not all, of its popularity. Here are the reasons why:

● Recognition of the time value of money. Essentially, the concept of time value holds that a dollar received today is worth more than a dollar to be received later because (1) inflation erodes purchasing power, and (2) a dollar received today can be invested to earn interest.

● Allowance of comparison of projects. You can apply the NPV technique to all types of projects and thereby can compare and rank your various options.

● Applicability for the life of an investment. NPV can be used to evaluate an investment over its entire life.

Although these advantages give NPV a considerable edge over the payback method in some areas, don’t make the mistake of thinking the NPV method will solve all your capital evaluation problems. NPV has some basic flaws that can, at times, lead to unjustified conclusions. First, it is difficult to forecast cash flow. NPV requires that cash flow from a proposed capital investment venture be projected for at least five years, and sometimes more. Obviously, such forecasts may be subject to serious error, particularly in a volatile business climate. Second, there is an assumption of steady reinvestment.

The NPV method assumes that all cash flows from the project can be reinvested at a chosen interest rate. (This rate is called the discount rate and is usually equivalent to the company’s cost of capital.) This may not always be possible. Finally, NPV does not measure the profitability of a particular project, only the cash flow. Actual profits in future years may turn out to bear little resemblance to cash-flow projections.

Even though the NPV method is not, in and of itself, a basis for judging the worth of capital spending proposals, it can be a useful tool in your decision-making process. As with the payback method, however, it usually works best when used in conjunction with other evaluation methods.

Understanding the Discounting Concept

Both NPV and the internal rate of return (IRR), the next evaluation method we will discuss, depend on the concept of discounted cash flow (DCF). DCF is based on a principle that most businesspeople instinctively understand, but nevertheless find difficult to convey. In simple terms, DCF recognizes that money has a certain time value. A dollar received today is worth more than a dollar to be received next year because the dollar received today can be invested to earn more money.

Specifically, each $1 that you receive today is worth roughly $1.08 the following year simply because you can reinvest today’s dollar to earn a risk-free 8 percent at present. In other words, a dollar that you are scheduled to receive next year is actually worth only $0.92 in today’s dollar. That’s a discount of 8 percent to make up for the interest forgone. Similarly, a dollar to be received two years from now would be worth approximately $0.86, with the 8 percent discount compounded over the two-year period. Over a three-year period, your $1 would be worth only $0.79, given a three-year 8 percent discount.

In a nutshell, that’s how the technique of discounted cash flow works. The projected cash flow from a particular project is discounted year by year. In theory, the final figure arrived at represents the money to be received in terms of current dollars.

Discounting to Find NPV

Once you’ve grasped the concept of discounted cash flow, it is a simple matter to calculate net present value. First, select an appropriate discount rate, one that represents the minimum rate of return that is acceptable for new capital investments. Usually, the average cost-of-capital rate is used as a hurdle rate, but you can substitute other rates. The discount rate should be in keeping with your company’s long- and short-term objectives. After selecting a discount rate, apply it to the projected cash flows for the project. Finally, total the cash flows. If the results are positive, the project will theoretically yield a profit. If not, there is good reason to question whether you will be able to recoup your investment.

Illustration: Say the ABC Company is now considering a $50,000 capital investment in a new piece of equipment. After $10,000 in installation costs, the new equipment is expected to yield annual net cash flows as follows:

Year 1 $15,000

Year 2 $15,000

Year 3 $15,000

Year 4 $17,500

Year 5 $20,000

Because the ABC Company’s average capital cost rate (see page 58) is 8.8 percent, it sets a dis¬count or hurdle rate of 9 percent. Each payment is then discounted by using a present value factor table, such as the one on page 63. Here is how the NPV calculations would look:

Year Net Cash Flow Discount Factor at 9% Present Value

0 ($60,000) — ($60,000)

1 15,000 .917 13,755

2 15,000 .842 12,630

3 15,000 .772 11,580

4 17,500 .708 12,390

5 20,000 .650 13,000

Total $22,500 NPV $3,355

As you can see, the $22,500 theoretical “profit” projected for the investment before discount¬ing boils down to a more mundane $3,355 on an NPV basis. Nevertheless, ABC should consider the investment: The company would not only recoup the investment but also earn a profit in the bargain.

No. of Years

5%

6%

7%

8%

9% Discount Rate

10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 .952 .943 .935 .926 .917 .909 .901 .893 .885 .887 .870 .862 .855 .848 .840 .833

2 .907 .890 .873 .857 .842 .826 .812 .797 .783 .770 .756 .743 .731 .718 .706 .694

3 .864 .840 .816 .794 .772 .751 .731 .712 .693 .675 .658 .641 .624 .609 .593 .579

4 .823 .792 .763 .735 .708 .683 .659 .636 .613 .592 .572 .552 .534 .516 .499 .482

5 .784 .747 .713 .681 .650 .621 .593 .567 .543 .519 .497 .476 .456 .437 .419 .402

6 .746 .705 .666 .630 .596 .565 .535 .507 .480 .456 .432 .410 .390 .370 .352 .335

7 .711 .665 .663 .584 .547 .513 .419 .452 .425 .400 .376 .354 .333 .314 .296 .279

8 .677 .627 .582 .540 .502 .467 .434 .404 .376 .351 .327 .305 .285 .266 .249 .233

9 .645 .592 .544 .500 .460 .424 .391 .361 .333 .308 .284 .263 .243 .226 .209 .194

10 .614 .558 .508 .463 .422 .386 .352 .322 .295 .270 .247 .227 .208 .191 .176 .162

15 .481 .417 .362 .315 .275 .239 .209 .183 .160 .140 .123 .108 .095 .084 .074 .065

20 .377 .312 .258 .215 .178 .149 .124 .104 .087 .073 .061 .051 .043 .037 .031 .026

To illustrate, however, how even a moderate shift in the discount rate can affect NPV calculations, let’s assume ABC decides that the cost of capital was climbing and that, from here on in, it would use a hurdle rate of 11 percent. Now the NPV calculations would look like this:

Year Net Cash Flow Discount Factor at 11% Present Value

0 ($60,000) — ($60,000)

1 15,000 .901 13,515

2 15,000 .812 12,180

3 15,000 .731 10,965

4 17,500 .659 11,532

5 20,000 .593 11,860

Total $22,500 NPV $ 52

Now the $22,500 profit has been transformed into a minuscule gain of only $52 over the five-year span. The project, therefore, is only marginally acceptable. As you can see, your experience with the NPV evaluation method will heavily depend on the hurdle rate that you’ve chosen.