Net Present Value Method | Formula | Steps | Merits | Demerits

Net Present Value Method

Net Present Value method is also called Excess Present Value (E.P.V) or Net Gain Method or Investor’s Method.

The time value of money is taken into consideration by NPV method and attempts to calculate the return on investment by introducing the time element factor. It recognizes the fact that a penny earned today is worth more than the same penny earned tomorrow.

The present values of all cash inflows and cash outflows are calculated separately over the entire life of the project by considering the firm’s cost of capital or a predetermined rate. The difference of present value of cash inflow over the present value of cash outflows is considered as net present value.

Steps involved in Calculation of Net Present Value

The following steps are taken in the calculation of net present value.

1. The first step is the determination of expected rate of return. The rate of return is based on the investment policy of the company and the nature of investment proposals.

Expected rate of return refers to an amount of profits to be earned or an amount of savings to be made or an amount of income to be available out of the total capital employed. It is otherwise called as cost of capital or cut off rate.

2. The second step is the assessment of the cost of the project. Generally, the cost of the project is paid in the first year itself. If the cost of the project is paid in the first year itself and there is no cash outflow in the subsequent years the cash outflow is equal to the present value of cash outflow.

Sometimes there may be cash outflow during the life time of the project i.e. as maintenance expenses. In this case, the following equation is used to find the present value of cash outflows.

[math]PVCO = CO_0 + \frac {CO_1} {(1+C)^1} + \frac {CO_2} {(1+C)^2}+ \frac {CO_3} {(1+C)^3}+ \frac {CO_n} {(1+C)^n} [/math]

Where

PVCO = Present Value of Cash Outflow.

CO = Cash Outflow, n = Number of years, C = Cost of Capital, 0 = Initial Period, 1, 2. 3 = I Year, II year and III year respectively.

3. The next step is the assessment of the economic life of the project.

4. Then, the management accountant can find the present value of cash inflows over the life of the project. If the cash inflows is uniform over the entire life of the project, the cash inflow is multiplied with the help of the present value of $1 received annually for N years table value.

5. When the cash inflows are not uniform throughout the life of the project. the following equation is used to find the present value.

[math]PVCI = \frac{CI_1}{(1+C)^1} + \frac{CI_2}{(1+C)^2} + \frac{CI_3}{(1+C)^3} + \frac{CI_n}{(1+C)^n}[/math]

Where,

PVCI = Present Value of Cash Inflow

CI = Cash Inflows, C = Cost of Capital, n = Number of years, 1, 2, 3 = I year, II year and III year respectively.

6. Now, find the difference between the present value of cash inflow and the present value of cash outflow.

7. If the present value of cash inflow is more than or equal to the present value of cash outflow, the net present value is positive. Such type of project is acceptable.

8. If the present value of cash inflow is less than the present value of cash outflow, the net present value is negative. Such type of project should be rejected.

9. If two or more mutually exclusive projects are evaluated, all the projects are ranked according to the NPV since the amount of investment is equal. A project which secures first rank should be accepted and all other projects are rejected automatically.

Merits of Net Present Value Method

The following are the advantages of the Net Present Value Method.

1. It is based on the time value of money.

2. It considers the earnings or savings over the entire life of the project. These earnings or savings are converted into the present value of money.

3. It helps to make a comparative assessment of different projects.

4. Under this method, the highest net present value project is recommended for implementation. It leads to maximization of profits to the organization.

5. It can be applied to even and uneven cash inflows patterns.

6. The NPV method is generally preferred by economists. Hawkins and Pearce state that this method is theoretically unassailable. If one wishes to maximize profits, the use of NPV always finds the correct decision.

Demerits of the Net Present Value Method

The following are the disadvantages or limitations of the net present value method.

1. This method does not indicate the rate of return which is expected to be earned.

2. This method may fail to give satisfactory answer when the projects are requiring different levels of amount of investment and with different economic life of the projects.

3. The application or usage of this method requires the knowledge of rate of cost of capital. If cost of capital is unknown, this method cannot be used.

4.The NPV method leads to confusing and contradictory answers in ranking of complicated projects.

5.Determining an appropriate discount rate is difficult in this method.

6. This method cannot be used for finding the number of years required to recoup the capital expenditure i.e. project amount.