Investment Appraisal: Discounted Cash Flow Method: Net Present Value (Copy)

10.3 Investment Appraisal

10.3.3 Discounted Cash Flow Method: Net Present Value (NPV)

1. Meaning of NPV

• Net Present Value (NPV) is the difference between the present value of cash inflows and the initial investment.
• Accounts for the time value of money: money received today is worth more than the same amount in the future.
• Positive NPV → Investment is worthwhile (creates value).
• Negative NPV → Investment is not worthwhile (destroys value).

2. Calculation of NPV

Steps:

1. Identify expected cash inflows from the investment.
2. Determine discount rate (often the cost of capital or required rate of return).
3. Calculate present value (PV) of each cash inflow using:

   PV = Cash inflow ÷ (1 + discount rate)ⁿ

   • n = year of the cash inflow
4. Add all PVs of cash inflows to get Total PV.
5. Subtract initial investment:

   NPV = Total PV of inflows – Initial Investment

3. Interpretation of NPV

• NPV > 0 → Investment is profitable; it adds value to the business.
• NPV = 0 → Investment breaks even; it neither gains nor loses value.
• NPV < 0 → Investment is unprofitable; it reduces value.

Example:

• Initial investment = £50,000
• Cash inflows: Year 1 = £20,000, Year 2 = £20,000, Year 3 = £20,000
• Discount rate = 10%

Step 1 – PV of each inflow:

• Year 1: 20,000 ÷ (1 + 0.10)¹ = 20,000 ÷ 1.10 = 18,182
• Year 2: 20,000 ÷ (1 + 0.10)² = 20,000 ÷ 1.21 = 16,529
• Year 3: 20,000 ÷ (1 + 0.10)³ = 20,000 ÷ 1.331 = 15,035

Step 2 – Total PV of inflows:
18,182 + 16,529 + 15,035 = 49,746

Step 3 – NPV:
NPV = 49,746 – 50,000 = –254 → Slightly negative, investment not recommended

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change A2 Level Business Full Scale Course