One of the most popular tool for evaluating the feasibility of the capital budgeting is the Net Present Value (NPV) method. As the project under consideration gives rise to cash flows in more than 01 years, so in such a long period of time, the money losses its value, to which we call time value of money. The amount of money which we expect to earn after 1 year, 2 years or more are discounted to the present value and accumulated together to find out the net present value.
Formula
NPV= PV (Present value) of Cash Inflows – PV (Present value) of Cash Outflows
Example
ABC is a manufacturing company engaged in the production of textile bed sheet. It is considering investing in a new plant which would increase its production capacity by 20 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c}. The investment required initially is $ 1,000,000. The plant is expected to give rise to cash flows of $ 100,000, $ 200,000, $ 300,000, $ 500,000 and $ 300,000. The discount rate to be used in the evaluation of this project is 10 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c}. Evaluate this project using NPV method.
Solution
We need to do a detailed calculation to take effect of the time value of money over the cash inflows in future periods as follows:
| Year | Cash Inflow/ Outflow | Discount Factor @ 10 {1bb28fb76c3d282be6cfd0391ccf1d9529baae691cd895e2d45215811b51644c} | Present Value |
| 0 | (1,000,000) | 1.0 | (1,000,000) |
| 1 | 100,000 | 0.909 | 90,900 |
| 2 | 200,000 | 0.826 | 165,200 |
| 3 | 300,000 | 0.751 | 225,300 |
| 4 | 500,000 | 0.683 | 341,500 |
| 5 | 300,000 | 0.621 | 186,300 |
Now we will calculate NPV by adding together all present value figures as follows:
NPV = (1,000,000) + 90,900 + 165,200 + 225,300 + 341,500 + 186,300
NPV = $ 9,200
As you can see that the project is going to yield positive cash flow of $ 9,200 to ABC. So, evaluating this project over the basis of net present value, ABC should undertake this project.
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