In: Accounting
The net present value method is used to evaluate capital investments. Describe this method. Be sure to address why the time value of money is an important component.
Ans- Net Present Value (NPV)
What is Net Present Value (NPV)?
Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.
The following formula is used to calculate NPV:
NPV=t=1∑n(1+i)tRt
where:
Rt = Net cash inflowoutflows during a single period t
i = Discount rate or return that could be earned inalternative investments
t=Number of timer periods
If you are unfamiliar with summation notation – here is an easier way to remember the concept of NPV:
NPV=TVECF−TVIC
where:
TVECF=Today’s value of the expected cash flows
TVIC=Today’s value of invested cash
A positive net present value indicates that the projected earnings generated by a project or investment - in present dollars - exceeds the anticipated costs, also in present dollars. It is assumed that an investment with a positive NPV will be profitable, and an investment with a negative NPV will result in a net loss. This concept is the basis for the Net Present Value Rule, which dictates that only investments with positive NPV values should be considered.
Example: Let us say you can get 10% interest on
your money.
Your $1,000 now becomes $1,100 next year. So $1,000 now is the same
as $1,100 next year (at 10% interest): We say that $1,100 next year
has a Present Value of $1,000. ... If you
understand Present Value, you can skip straight to
Net Present Value.