- Describe the net present value method
Net present value is defined as the difference between the present value of cash inflows and the present value of cash outflows over a period of time. It is used in capital budgeting to determine the profitability of a potential investment or project.
A positive net present value is a good thing, and denotes a project that will exceed the anticipated costs, both defined in present dollars. If an investment shows a negative present value, the company would lose money on the investment or project and should not proceed. So with this rule in hand, it would make sense to only follow through with projects with a positive net present value, or those that would make the company more money that the initial investment. It wouldn’t make sense to invest money that would not be made back, plus a profit, right?
Using this method can be challenging, as there are many ways to determine the value of future cash flows. As an example, if we are using the savings in labor as a part of the positive cash flow for an equipment purchase, if wages go up substantially due to economic change, it could create a much better positive cash flow. But if over the same time, economic pressure brings down the labor rate, it could have the opposite effect on the potential positive cash flow of the same purchase.
A restaurant is considering the purchase of an additional location in a neighboring town. Looking at potential revenues of the additional location for the next five years, discounted to present value—let’s say comes to $250,000. If the owner of the additional location is willing to sell the restaurant for $250,000 or less, the purchase makes sense. If they are not willing to sell for less than $250,000 we would pass on this purchase. The awesome thing would be if the owner offered to sell for $100,000, creating a gain on the investment called intrinsic value.
There are pitfalls to the net present value approach, as there are will any of the methods. In our restaurant example, what if the current owner is selling due to impending competition moving in, or maybe a new highway is coming through that will divert traffic? Also, the payback period is only the five years as noted. Once our investment is earned back, will we continue to make enough money to keep the space open profitably? So many questions when we are making these capital budgeting decisions!
For more practice check out this example on Net Present Value Method.