Q. 162  Explain the usage of Net Present Value in decision making by providing relevant examples.

 

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Benchmark Six Sigma Expert View by Venugopal R

 

The cash in hand has an advantage of having the ability to be invested immediately and enable earning of returns. Hence the value of same amount of cash that we would get in future is always lower than the same amount we have now.

 

Net Present Value compares the value of the amount invested today to the present value of the future returns from the investment, after discounting them to a given rate of return.

 

Based on certain inputs, the NPV helps in deciding whether an investment is expected to be profitable or not. The profitability is, however, not based on just the absolute value of the return of investment, but after applying the discount based on the prevailing interest rate.

 

For instance, let’s say we have a certain amount of money in hand and it is expected to earn interest at the rate of 7% per annum through normal financial investments. If we invest the money on a business, we should expect a return that is more than that obtained through a normal financial investment. This can be ascertained by the NPV calculation.

 

Let’s take an example where we have a sum of Rs.100,000 for investing in a business. We expect a future cash flow return of 160,000 after 3 years. We need to know if this would be a profitable venture, taking into account the prevailing rate of interest at 7%. We may provide the inputs into the NPV calculator available at https://www.benchmarksixsigma.com/calculators/net-present-value/ . We get a positive NPV, which indicates that the venture is profitable, over and above the expected rate of interest. On the other hand, if the expected future cash flow return had been 120,000, you can observe that the NPV turns negative, even though the absolute net yield is 20%.

Thus, the NPV acts as an indicator to assess the worthiness of the business investment, considering the prevailing interest/discount rates.

 

However, it needs to be remembered that NPV is an indicator that needs to be considered as just one input, and business decisions are taken considering several other factors.

Hi there,

 

In a nutshell, NPV (Net present value) is a tool that has been used by most decision makers widely in various industries to gauge the profitability of a project in years to come to check its feasibility.

 

Let's understand this in details with below example,

So, we have a project manager who wants to check if an investment in a project that he wants to pursue will be profitable or not in given time horizon ( let's say 5 years).

In order to check this, he first will forecast the future cashflows year on year and discount these cashflow values to the present day (at the time of investment) using a discount rate (The discounting rate is actually a rate to find the time value of money over the period of time considering various parameters).

 

Let's say,

-> (FC1), (FC2), (FC3), (FC4), (FC5) are the future cashflows in year 1,2,3,4,5 respectively

-> discounting rate is R%

 

After discounting these cashflows to the present day we add these values and we have a present value of all our future cashflows.

 

Present value of future cashflows = ((FC1)÷(1+R)^1) + 

((FC2)÷(1+R)^2) + 

((FC3)÷(1+R)^3) + 

((FC4)÷(1+R)^4) + 

((FC5)÷(1+R)^5)

 

Now, to check the feasibility of this project, we just need to subtract the Investment value from the present value of our cashflows.

NPV = (Present value of future cash flows) - (Investment value)

As a result of this subtraction, we get our NPV of the project.

Now, if this NPV comes out to be positive, our investment is fruitful and if it is coming out be negative, it is a loss making investment and we shouldn't be going for it.

NPV = positive, -> Investment is profitable

NPV = negative, -> Investment is loss making

NPV = 0, -> Break-even point

 

Hope, this clears and helps in getting the  basic understanding of NPV and will also help you in check the feasibility of your future projects.

 

Best wishes

Net present value helps us understand present value of future earnings. For a project to go ahead NPV has to be positive as it takes care of all the expenses. If there are two projects, project 1 with NPV of 10 and NPV of project 2 is 12 then clearly the decision is 'go' for project 2. 

On 5/24/2019 at 2:17 PM, Vishwadeep Khatri said:

Q. 162  Explain the usage of Net Present Value in decision making by providing relevant examples.

 

You may use the calculator at the following link - https://www.benchmarksixsigma.com/calculators/net-present-value/

 

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Net Present value, useful tool for the top management to identify and implement the profitable project among the multiple projects. It is based on the inflow of cashes over a period of time including the present investment for the completion of project. A positive NPV denotes a profitable project whereas a negative NPV denotes the loss.

 

  Ex: In a diagnostic lab when investing a new instrument for investigation, NPV is measured to see whether it is profitable or not

 

a. cost of instrument = 4,00,000 /-

b. reagents required for performing tests for 3 years = 1,00,000 /-

 Net investement = a + b = 5,00,000 /-

Expected cash flow in three years = 5,50,000 /- and rate of interest of 8%

The Net Present Value in this case is -63,392 /-
as the Net Present Value is negative the current plan of investement is not profitable. Hence the idea of investment should be reconsidered. 

 

Net Present value refers to the difference between the amount of cash flow achieved and the quantum of cash invested in a project / activity. In most of the situation, the organisational leaders are required to deliberate on the decision making in terms of projects profitability based on the cost - benefit analysis. Net present value (NPV) helps in order to process that decision making. After the NPV calculation, if it comes out to be POSITIVE, than the project or activity is said to be PROFITABLE or if the NPV comes out to be NEGATIVE, activity/Project is said to be NOT PROFITABLE.

 

EXAMPLE : A Pharma company is required to make a strategy for one of the underutilized  packaging line. When the Team calculates the investment required to bring product A and Product which are the two available option, they find the the investment required for product A for till Break even point i.e., next "n" years is "X" times more than the investment required to roll out product B in the proportionate time value. However the cash return or cash flow for Product A is found to be lower than the product B. This helps the team to do a comparative analysis between the investment and the return and hence estimate the Return of Investment on a particular project.

 

Another example can be in terms of determining the best decision for industrial expansion. Suppose the management needs to chose among options A,B...N which represents the geographical locations for business expansion. What makes sense is to estimate the profitability through comparative analysis. This can be done by determining HOW MUCH CASH THE PARTICULAR INVESTMENT can generate.

 

Like this it finds its usage in various sectors, like choice of consumer goods for the consumer, decision to launch an entirely new automobile model, business diversification, New Technology Implementation etc.

 

In general, Money we have in hand at the present moment is worth more than money we can collect later on. That's because we can invest it or earn interest on it. Future money is less valuable because of inflation. NPV allows us to translate the amount of money we expect to make from an investment into today's dollars. To calculate it, we will need to know the upfront cost of the investment and the projected revenues for each year. We'll also need a discount rate, which is a company-specific number set by our finance department.

 

NPV is therefore a strategic and concise comparative analysis tool which helps vociferously in terms of decision making and stands a chance for best possible estimation in terms of Returns on Investment.

 

 

 

Mohit Rawat's answer provides a clear and concise answer and, hence, is the chosen best. Read through Dr. Gautam.and Sreyash's answers for more examples.

 

Benchmark expert view is provided by Venugopal.