In this lesson we'll take a look at why businesses use net present value, what they need to know to calculate it, and how it can help them make business decisions.
Capital Budgeting and NPV
Say you have a business that's doing well enough to expand through investment. How would you choose what kind of investment you wanted? You want to make sure you would get a good return on that investment, so that you'll make money from it in the future.
Businesses are very interested in the return on investment. They calculate the Net Present Value (NPV) of a variety of investment opportunities to find the one that will return the most.
Basically, they are considering that the value of money they have now is worth more than that same amount in the future. This is due to opportunity costs, the loss of potential gain by choosing one alternative over others, and inflation.
Businesses use NPV most often in capital budgeting, where they decide whether to buy new machinery, expand the factory, or research and develop new products. They want to know which of these potential investments would make them the most money in the long run. The NPV tells them how much it would earn in present dollar values.
In calculating NPV the investor needs to know the total investment costs. This includes:
the buy in cost
how much it will earn each year
the discount rate, which is the interest rate needed for some money now to equal a certain amount later
how long the investment is expected to last
They are looking for investments where the earnings are more than the costs, in other words, a positive NPV.
This sounds pretty straight forward, but if you look at what they need to know to calculate NPV, there is a lot, and I mean a lot, of guess work and assumptions. So, while NPV is a fairly easy calculation, it isn't a fool-proof method. But it is at least a start. Let's take a look at an example.
Project 1: New Machine
Let's say the stockholders in Brown's Business thinks it's time to grow the business and want the Chief Financial Officer (CFO) to invest $300,000 to make this happen. There are a couple of investments they are considering:
Project 1: new machinery for the production facility. Project 2: a brand new building in a great part of town.
The CFO needs to calculate the net present value for each project to see which one would give them the most bang for their buck.
Project 1: an investment in a new type of machinery that can increase productivity on the manufacturing floor has a discount rate of 10% and an estimated increase in revenue of $80,000 per year.
They start out with a negative return because they had to pay out $300,000.
In the next year, they divide the discount rate by the return or profit for that year (1.1 / $80,000) and see the first year, their actual return is $72,727.27.
The next year, they square the discount rate (1.10 x 1.10 = 1.21) and divide the $80,000 by that number. So, in year 2 they are earning $66,115.70. Remember, every year in the future, those investment dollars are going to be worth less.
In year three, they cube the discount rate (1.10 x 1.10 x 1.10 = 1.311), and so on.
At the end of the five year investment period, they are looking at an overall profit of $4,179.88.
So, they've made just over four grand on their $300,000 investment. That's okay I suppose. But let's take a look at their other investment opportunity.
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Project 2: the investment in a brand new facility. They got a great deal with only a 6% discount rate and they anticipate an increase in revenue of $85,000. It looks like even though project 2 is only netting a $5,000 per year increase over project 1, because of the lower discount rate, project 2 will garner them almost sixty grand. Way more than project 1.
Project 2 looks like the way to go, right? Right, unless, as I mentioned before, their estimates for the actual costs and revenue of the investments were off. The estimated NPV is only as good as the data that was used to generate it. If I were the CFO of Brown's Business, I'd be looking really hard at the numbers generated for Project 2 to make them as accurate as possible before choosing that investment.
Net present value is used by businesses to calculate the future return on investments made in the present for capital projects (also known as 'sources of value') such as purchasing a new machine, expanding their facilities, or researching and developing a new product. The understanding is that earning a dollar today is worth more than a dollar earned in the future because of opportunity costs and inflation.
The information needed to calculate NPV includes
discount rate (interest rate needed for a certain amount to increase to a higher amount later)
Much of this information is speculation, and unforeseen costs may occur or the yearly earnings may be higher or lower than the estimate. To make investment decisions, businesses are looking for a positive NPV where the earnings will be more than the costs of the investment.
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