To assess the effectiveness of investments in something, there are quite a few indicators. And one of them, which is of interest in the framework of the article, is the net present value of the project. What is it and how important is it for an investor? This and not only can be found out by reading the contents of the article.
What is net present value?
First, we’ll study the terminology base. Net present value (the definitions of “current” or “present value” are also used) is an indicator that represents the difference between all sources of profit and expenses at the time of project evaluation. In other words, it allows you to show what profit a person who has invested in a business can count on if he wants to get everything now. But it is possible to calculate the indicator of net present value only after the initial investment costs have been paid off and, if there were, recurring cash expenses associated with the implementation of a specific project.
Generalized counting option
When investing in something, it is necessary to take into account that the general formula of the NPV will look like this: the summed value of the amount of income for each year, from which the size of the initial investment is taken away. But here it is necessary to make small amendments. Thus, income should be adjusted for inflation so that the amounts considered are the same in terms of purchasing power - it is important to get a net discounted income. The formula depends on payback period the project in question. You can also translate the resulting profit into a currency that is weakly amenable to inflation, in order to then be able to compare profitability relative to the world market.
Interpretation of net present value
So, some value is received. If it is greater than zero, then the investment is profitable. But such a fact is not enough to invest your money. Therefore, it is still necessary to decide whether to invest. And with this, the level of profitability helps. So, if at the time of the theoretical end of the project term, sum all the money adjusted for inflation and divide by costs, you get a coefficient that indicates the effectiveness of the invested funds. So, for example, if the ratio is 2.1, then this means that for every ruble invested, you will get 2 rubles and 10 kopecks. As a rule, the higher the yield, the greater the risk of not getting it. Therefore, NPV also acts as an indicator of risk. To better understand the mechanism of action, you can familiarize yourself with the example below.
Project Evaluation
Suppose a corporation is considering whether a new product line is needed on the market. They will have the costs of the development, launch, operation of industrial facilities, as well as profits. The calculated term is 6 years. At the beginning of the implementation, a one-time outflow of funds from the company’s budget in the amount of 1 000 000 rubles will take place, which already includes expenses on mechanisms, staff selection and training. Other possible expenses are expected in the amount of 100,000 p. And the inflow of funds will amount to 500,000 rubles.
After receiving a net profit (with which all taxes have already been paid) in the amount of 250,000 r, the company places them in a bank at 20% per annum for the duration of the project (in the first year it is 5 years, then less). As a result, this project will be able to pay for itself nominally for the 4th year, and the fifth will work for the founder.The fact that the money is in the bank and interest is accrued on it will help to avoid the negative impact of inflation (albeit not in full). For simplicity of this situation, it can be decided that the deposit allows you to fully cover inflation, then the net discounted income of the project will be in the amount of 250 thousand rubles for 5 years or 50,000 per year. Of course, it may seem that this is not enough, but the author of this article took the numerical values, as they say, from the ceiling, and they had one goal - to explain the NPV mechanism. Under real conditions, the amounts of money will vary greatly.
Advantages and disadvantages
To evaluate a specific project, it is necessary to highlight the basic initial parameters. Each of them is set a series of some values and indicates the probability of the event. For each group of indicators, the probability of occurrence is calculated. Then it is necessary to calculate the mathematical expectation and the final result - this is the probabilistic net present value. This method has its advantages:
- Clearly defined criteria that influence decision making.
- The value of money is taken into account in the calculation formulas.
- Typically, an indicator is the level of riskiness of a project. The larger the ratio, the greater the chance of losing money.
And its cons:
- For multidisciplinary projects, the problem of the correctness of the net present value may arise.
- It should be borne in mind that the NPV formula does not take into account the probability of the development of events according to the adopted scenario.
- There are also certain difficulties for comparing alternative projects, which will now be discussed.
Features when comparing alternative projects
You should be careful when calculating the effectiveness of investments in multi-parameter investments. By them we understand the contributions of money to projects in which three parameters differ:
- amount of investments;
- financial results for the year;
- billing period.
This can be explained in a simple situation: for example, two projects have different profitability. But at the same time, when buying for the same amount in terms of a unit of invested funds for one year earlier, an unprofitable offer will be the best. It can be concluded that for the sake of completeness, something else needs to be considered. And such a conclusion is correct: for comprehensiveness and reliability of information on the possibilities of alternative projects, it is desirable to determine the net present value, the estimated period and the amount of investment. All these parameters were combined in the index of the rate of specific growth in value. Due to the fact that it takes into account significantly more criteria than the net present value, it is better suited for assessing investment attractiveness.
