Projects should add financial value to an organisation. This Project Net Present Value blog is part of a set of four blogs looking at the financial methods of assessing projects
I wrote about project selection in an earlier blog, however that blog over-viewed both financial and non-financial methods for project selection. This blog will look at the advantages and problems with these financial methods.
Net Present Value
The concept of the value of money is best explained using an investment example with an interest rate.
Imagine that I had £909 to invest today, at an interest rate of 10%.
In a years time, I would have: (909 x 1.1) = £1000
Or put this another way, the present (todays) value of £1000 in 1 years time is £909.
So for any value of money, at 10% and in 1 years time, just multiply by a discount factor of .909.
This method could be used for any interest rate, and repeated for each year into the future.
Therefore my £909 today, at an 8% interest rate would be worth in 2 years: ((909 x 1.08)) x 1.08 = £1,060
The present value of £1,060, 2 years into the future, at 8%, is £909.
Taking the ratio of 909/1060 gives us a discount factor of .858.
Present Value Equation
Net Present Value (NPV) is a discounted cashflow technique which discounts future earnings to today’s values. Therefore the percentage used is often called the discount rate, and the discount factor is the number used to reduce future earnings.
An equation can be written to express the present value for any discount rate, and any number of years:
So for our previous example:
Present Value Tables
Luckily, we do not have to remember or use the equation when we have recourse to either a pre-printed table or Excel!
The formulae to use in EXCEL is shown below.
This EXCEL file is available from my resources page.
Pre-printed tables may look as follows:
Applying Net Present Value to Projects
Any money invested in the project is usually indicated as today’s money – or at a factor of 1 (long projects are exceptions, which may have several negative outgoings), and money leaving the company is negative, with future incomes as positive.
Using the discount factors, we can take the anticipated future incomes generated by any project, and add them up to give a total (or NET) value in today’s money.
Project Net Present Value Example
In the following example, £100,000 is invested in a project, and a 10% discount is to be used.
Anticipated returns in future years are as follows:
- Year 1 £30,000
- Year 2 £30,000
- Year 3 £40,000
- Year 4 £50,000
- Year 5 £50,000
To calculate the NPV, we have to multiply these incomes by the relevant discount factor, total them up, and ten subtract the initial investment value.
The NPV for this project is therefore £47,290. This could be compared to a project with a similar investment figure to see which provides the larger benefits.
Any NPV greater than zero, means that the project generates a profit using discounted techniques. A negative value indicates that the project does not recover the investment. Clearly, the larger the figure the better.
Problems using the Net Present Value
This comparison of projects suggest an issue. You can only directly compare projects with the same investment amounts. If two projects have two different investment amounts, you could calculate a ‘profitability index’ as follows:
This would give a figure that can be used to compare projects of differing values.
Other issues may include:
- When comparing two projects, account must be taken of the relative risks for each project
- All future incomes and savings are estimated – and may be wrong!
As with all projects, there are other factors that should be considered when making a judgement.
All of these project finance techniques are shown in this video playlist:
The Net Present Value approach is a ‘discounted’ approach which takes into account the time value of money.