Net present value (NPV)
Net present value is a method for assessing the likely success of capital expenditure projects and whether to invest in them or not.
What is it used for?
It is used for calculating whether particular projects will be good investments and helps towards understanding the level of risk and return involved in new ventures. It can be used to help with decision making about buying; to determine whether to purchase new equipment for projects or not, for example.
How do I use it?
NPV is calculated by a formula. You will need to
- Estimate the amount of money that you would receive if this expenditure occurs
- Understand the rate of interest that could be received if capital funds were invested instead
- Estimate the number of years that it will take for the amount of money to be made.
You can then plug these figures into the formula below to understand the Net Present Value:
S = the estimated future amount to be received
r = the rate of interest that could be received if the capital expenditure funds were invested instead.
n = the number of years into the future at which the future sum is projected to be realised.
The following considerations are important:
- All future cash flows estimated must be set at current values
- Capital expenditure is assumed to first occur in year zero.
If your result is a positive NPV, then this implies that your company’s value will rise as a result of making the capital expenditure.
If your result is a negative NPV, you should probably not make the expenditure.
What are its limitations?
One drawback of NPV is that financial factors (increase in returns) are not necessarily the only reason for capital expenditure to go ahead. There may be other reasons for expenditure, such as increasing reliability or performance. It is also difficult to project future cash flows, due to taxes, which can fluctuate.
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