Net present value. Present Value

2024 Author: Henry Conors | [email protected]. Last modified: 2024-02-12 02:48

In modern economic terminology, it is quite common to find such a term as "net present value", meaning the estimated value that is used when comparing various investment options.

One of the most important and common decisions made by business entities is the question of investing in other enterprises. Thus, every year millions of rubles are invested in factories or their equipment, which will function and bring additional profit for many decades. The future cash flow that an investment can bring is often subject to some uncertainty. And if plants or factories have already been 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 (depositor) incurs irretrievable losses.

Terminology

Net present value characterizes the current amount of cash resources required to receive future income equivalent to its counterpart receivedfrom 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 position of analyzing the economic efficiency of a deposit of 100 rubles on a deposit or in an investment project that can bring the same 110 rubles, the present value will be the same.

There is also an investment project profitability index - this is the result of dividing the net present value by the total value of discounted investments (investment costs).

Determining the expediency 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 that should “return” to the investor. This amount is compared with the projected costs, however, when making 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 monthly. 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 interest capitalization on the deposit.

In the economic literature, one can also find such an “academic” formulation: the net present value of an investment project is a positive balance of financial resources obtainedall cash receipts and expenditures. Its amount is reduced to the initial time point (date of commencement of the investment project).

The result shows the amount of money that an investor can receive after the implementation of the project. Often the present 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.

Project net present value: calculation formula

So, when calculating this indicator, the following formulas are used:

• NPV=SUM (CF_t / (1 + i)^t);
• NPV=-IC + SUM (CF_t / (1 + i)^t),

where:

t - number of years;

CF - payment in t-years;

IC - invested capital;i - discount rate.

Discount factors

Net present value can only be reliably determined if the discount rate is chosen correctly. Based on the value of this indicator, you can find the corresponding coefficients for the period for which the analysis is carried out.

Only as a result of determining the value of income 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's take a closer look at its meanings:

• positive valuewill show that in the billing period cash receipts in discount terms will exceed the same amount of investments, and this contributes to an increase in the value of a business entity;
• negative value indicates the absence of the desired rate of return, which leads to certain losses.

Consideration of alternative investment options

Often, before investing their own funds in a particular project, investors ask themselves the question: what discount rate should a company use when calculating net present value? The answer depends on the availability of alternative investment opportunities. For example, sometimes, instead of some type of investment investment, an enterprise uses its financial resources to acquire a different type of capital that can bring more profit. Or a business entity purchases bonds, which are characterized by a guaranteed presence of their own profitability.

Investments with equal levels of risk

There is such a thing as "like" investments. These are investments with the same level of risk. It is known from theory that the higher the risk of an investment, the higher the level of income, and, accordingly, the net present value. Therefore, an alternative investment in this project is an income for which there is a possibility of receiving it in the same amount with investing in another project or an asset with the same level of risk.

To assess the degree of investment risk, it is necessary to assume the existence of a project that is not related towith no risk whatsoever. Then risk-free income is taken as the opportunity cost of investments. An example of such income is the purchase of government bonds. When calculating the project for ten years, the business entity will be able to use the annual interest rate on the relevant government bonds.

Summing up the above material, it should be noted that this economic indicator quite successfully helps the investor in determining the appropriateness of investing free funds in a particular production.