Net Present Value (NPV) (Cambridge International A-Level Accounting)

Spec point — how to apply the following capital investment appraisal techniques: – net present value (NPV) the advantages and disadvantages of these capital investment appraisal techniques

Net present value (NPV)

What is the net present value of an investment?

• The net present value calculates the value of future cash flows in today's money by using discount factors

• It accounts for the time value of money

  • A dollar received today is worth more than a dollar received in five years

• Owners usually prefer investments which have a higher net present value

• If the net present value is positive, then the project returns more than the cost of the capital

  • These projects are normally accepted

• If the net present value is negative, then the project does not cover the cost of the capital

  • These projects are normally rejected

What are discount factors?

• A discount factor tells you how money in the future is worth today

  • For example, a discount factor of 0.909 means $1in the future is worth $0.909 today

• Discount factors are based on a discount rate

  • A discount rate of 10% means that the currency in any year is worth 10% more than the following year
  • It is assumed that the discount rate does not change between years

Exam Hint You do not need to memorise discount factors or learn how to derive them. You will be given the relevant discount factors in the exam question.

How do I calculate the net present value?

• STEP 1 Calculate the net cash flow for each year

• STEP 2 Multiply each year's net cash flow by the discount factor for that year

  • The discount factor for Year 0 is always 1.000

• STEP 3 Add together all the discounted net cash flows to find the NPV

  • Include Year 0

Exam Hint Set out your calculations in a table to make sure each net cash flow is multiplied by the correct discount factor.

What are the advantages and disadvantages of the net present value method?

Advantages

• It accounts for the time value of money
• It considers all cash flows over the project life
• It is the most accurate method in theory

Disadvantages

• It requires a discount rate to be chosen

  • This can be difficult in practice

• It is very sensitive to the chosen discount rate

• It is more complex to calculate and explain to non-specialists

Worked Example The directors of D plc are considering the purchase of a new machine, costing $220 000, to manufacture a newly developed product, Product Omega. The directors intend to manufacture the product for only four years, after which the machine will have zero residual value.

The directors have estimated the following net cash flows arising from the project:

Year	Net cash flow ($)
1	45 000
2	60 000
3	105 000
4	30 000

The cost of capital is 10%. The discount factors for this are as follows:

Year	Discount factor
1	0.909
2	0.826
3	0.751
4	0.683

Calculate the net present value (NPV) for the new machine.

Answer:

Multiply each net cash flow by the corresponding discount factor

• The discount factor for Year 0 is 1.000

Year	Net cash flow ($)**		Discounted net cash flow ($)
0	(220 000)	(220 000) × 1.000	(220 000)
1	45 000	45 000 × 0.909	40 905
2	60 000	60 000 × 0.826	49 560
3	105 000	105 000 × 0.751	78 855
4	30 000	30 000 × 0.683	20 490

Add together the discounted cash flows

Year	** Net cash flow ($)**	**Net present value ($)
0	(220 000)	(220 000)
1	45 000	40 905
2	60 000	49 560
3	105 000	78 855
4	30 000	20 490
		Final answer: (30 190)