Question

Define contingent net present value (NPV). Outline and explain the differences between standard and contingent NPV.

Answer 1

Solution:

In the context of contingent projects, the contingent net present value may be used to refer to a range of reasonable values of estimated future cash flows which is subject to the occurrence of a specific event or investment.

No assurance can be given that these estimates will be accurate, and actual future results could differ materially from those anticipated since this is dependent on investment in other supporting projects.

A contingent project usually refers to a project that can be accepted if and only if, a certain project or projects are accepted. Therefore it is contingent or dependent on the acceptance of other projects.

For example, if there is a proposal for a project to build a school in a remote location, other investments may also be required in terms of adequate infrastructure such as connecting roads, transport facilities, etc.

The standard meaning of Net Present Value as we know it refers to the difference between the Present Values(PV) of cash inflows and outflows. If project A has a greater positive NPV compared to Project B, we select the former. This usually forms part of the capital budgeting decision of a company and is used to analyze the profitability of different projects.

Difference between contingent net present value and standard net present value:

1. Independent nature of projects:

The standard net present value can be used to indicate profitability of investing a specific amount of capital into a project. This is usually used with respect to independent or mutually exclusive projects.

The contingent net present value indicates the estimated financial value of a project subject to other related investments. Hence, this is related to dependent projects.

2. Discount rates and risk consideration:

Standard net present values may have a lower discount rate based on risk factors. On the other hand, contingent projects may be riskier due to dependency on other investments and as such, the discount rates may need to be adjusted upward.