Net present value (NPV)

Whether you’re looking to grow your business or simply maintain your competitive position, making investments, such as purchasing a building, installing software or buying equipment, is a must. When faced with different options, it is essential to be able to compare them in order to choose the most advantageous one. That’s where net present value, also called net present worth, comes into play.

Net present value is a method for assessing an investment. You can use it to determine whether a project is profitable, but also to compare its profitability to other projects.

Although there are other methods you can use to assess an investment’s profitability, net present value is, without a doubt, the best and most frequently used. This article aims to help you understand why by presenting net present value in detail, including how to calculate it and how it can be useful for business owners.

What is net present value?

Net present value is a method for financially assessing an investment project. It’s one of four traditional methods you can use to carry out this analysis. The three other methods are:

• Internal rate of return
• Payback period
• Accounting rate of return

According to Dimitri Joël Nana, formerly Director, Portfolio Risk at BDC, “Generally speaking, net present value is the most robust method for calculating an investment project’s profitability.”

2 advantages of net present value for assessing an investment

1. Net present value is a better way to compare projects than the internal rate of return, as it more accurately takes into account the size of a project and cash flow over time.
2. Net present value takes into account the time value of money, unlike the payback period and the accounting rate of return.

This second point is especially important. A dollar today isn’t worth the same as a dollar in the future.

Net present value determines the future value of all cash flows and compares it to the current value using a discount rate, as presented below. This allows you to assess the true value created by a project, while taking into account the time, risk and cost involved.

Without this assessment, a project could seem profitable on paper but actually generate less value than expected, or even destroy that value. That’s why net present value is considered the most reliable tool for comparing and choosing investment projects.

What’s the difference between net present value and present value?

The difference between net present value and present value is simple. A project’s present value is the value of all future cash flows today, whereas its present net value corresponds to that value less the initial investment.

In other words, the difference between present value and net present value is that the latter also takes into account the initial amount invested, which will help you determine if an investment is profitable.

How is net present value calculated?

The net present value method calculates the net financial losses and gains while discounting all estimated future inflows and outflows. More specifically, it corresponds to the difference between:

• the discounted value of estimated future cash flows that will be generated by the project (e.g. expenses, revenue or savings)
• and the amount of the initial investment

You can use this method to calculate the time value of money in order to assess your long-term projects.

Formula for calculating net present value

Simply put, the net present value formula consists in calculating the present value of the expected cash flows for each year of an investment project, and then adding them together.

It’s important to note that in the above formula, the initial investment is considered a negative cash flow allocated to the first period. The formula can also be interpreted as follows:

Here, the initial investment is subtracted separately, and then the discounted cash flows are added together as of the following period (t=1), whereas in the first formula, the initial investment is considered a cash flow in the initial period (t=0).

In all cases, the cash flows used to calculate the NPV are before taxes. They are positive in the case of inflows and negative in the case of outflows.

As for the periods themselves, they can be months, quarters or years, depending on the duration of the project and the granularity of the analysis sought.

In addition, Nana advises businesses to always carry out a sensitivity analysis. This entails calculating at least three NPV variants based on different cash flow values and discount rates: a baseline scenario, an optimistic scenario and a pessimistic scenario.

According to Nana, “this approach will help you better understand the impact of an unexpected variation in the different variables on the project’s profitability. It will also help you prepare for uncertainty and make more informed decisions.”

Example of an NPV calculation for a real estate investment

Let’s imagine that a commercial property purchased for $3 million that generates annual rental income of $50,000 is sold three years later for $3.5 million (after taxes).

If we assume a discount rate of 10% and that the investment project will span three periods, the calculation would be carried out as follows:

Based on the net present value, this real estate investment would not be profitable.

What does a negative net present value mean?

A negative net present value indicates that an investment project isn’t profitable. In other words, it destroys value for the business.

More specifically, a negative net present value means that the discounted cash flows generated by the project are less than the initial investment.

Conversely, a positive net present value means that the project creates value for the business.

How can investment projects be compared using the net present value?

All things being equal, business owners should choose the project with the highest net present value.

However, it can make sense to carry out a project for reasons that aren’t strictly financial, even if it has a negative net present value.

Example of an NPV calculation for an investment in production equipment

Let’s look at an example from the manufacturing industry. Let’s imagine that a company is considering investing in software with a three-year life cycle, which costs $20,000 after taxes.

If the company anticipates efficiency gains as well as a cost reduction of $8,500 after taxes, and its discount rate is 10%, the net present value would be calculated as follows:

Based on the NPV, purchasing this software would be profitable.

How is the discount rate determined?

The main challenge when calculating net present value is determining the discount rate. It’s important to choose a realistic rate, as this figure will be used to convert future cash flows to today’s dollars. If a rate is too low, you could overestimate a project’s profitability, whereas if a rate is too low, you could mistakenly reject a profitable project.

There are three methods for calculating the discount rate. Each method is useful, but they are generally used in different contexts:

1. Weighted average cost of capital

The weighted average cost of capital (WACC) is the average rate that a business pays to finance its assets. If your goal is simply to see whether a project will create value for the business, this simple method may be appropriate.

2. Reinvestment rate

The reinvestment rate corresponds to the average return the business generates on its investments. This method may be more useful than the first in a situation where available capital is limited. The reinvestment rate translates to the opportunity cost of a project rather than a financing cost, which could be lower.

3. Hurdle rate

In this case, the discount rate is calculated based on the investment project’s hurdle rate, which is based on the business’s minimum acceptable rate of return for a project. For example, if the business achieves an annual return of 10%, the discount rate will be 10%.

The hurdle rate generally reflects the level of risk associated with the project. The higher the risk, the higher the rate will be.

This method is often used when the business has specific internal criteria for selecting its investments.

How can net present value be useful for entrepreneurs?

First and foremost, net present value is an indicator that allows business owners to determine the profitability of a project in order to decide if they should invest in it. Some projects may seem promising on the surface, but the NPV calculation will show whether they might actually create or destroy value for the business.

Suppose a business is considering several projects at the same time, such as choosing to purchase one type of software over another or whether to move or expand its current facilities. In that case, this calculation can be used to estimate which option will create more value in the short term.

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