The net present value (NPV) of an investment

We recently talked about the return on investment (ROI) of a project, which allows to know if this project is viable.

In the majority of cases, when the project has a negative ROI, it will be rejected, because from a quantitative point of view, it is not profitable. In some cases, however, a company may decide to engage in a project with a negative ROI if it knows that it could create synergies or indirectly have positive impacts in the medium or long term.

In situations where cash flows - cash inflows or outflows - occur at different points in time, generated by a project or investment, the net present value - or NPV - is a quantitative tool that can support decision making. decision.

The NPV is one of the most popular and relevant methods of evaluating future cash flows because it incorporates the concept of the time value of money.

The NPV calculation can be separated into 3 steps:

On the one hand, it is necessary to determine the cash flows related to the project.

Example :

A company evaluates a new project. To achieve this, it will have to incur an initial expenditure of $1.5 million. Over the next five years, it will collect sales and make disbursements for materials, supplies, labor costs and overhead. At the end of the fifth year the asset will be sold for an amount of $150,000 after taxes.

The net cash flows after tax (receipts less disbursements) related to the project for each of years 1 to 5 are:

The next step is to determine the discount rate to use to reflect the time value of money given the level of risk associated with the project.

A company could decide to use as a discount rate:

- Bank of Canada inflation rate

The inflation rate is rarely used, considered to be very conservative, it only ensures that the profitability of the project takes into account the increase in the cost of living in general.

- The required internal rate of return

This rate can take into account various elements such as: the risks related to the project, the internal policies of the company (to undertake only the projects whose return is higher than 10%).

- The weighted average cost of capital

This rate takes into account the financial structure of the company.

If the company uses the debt (bank loan) to finance its assets, it will take the interest rate charged by the bank on the loan.

In a situation where the company would like to use its funds, it will be necessary to use the cost of equity which can be calculated using a financial model called CAPM:

Cost of equity according to the CAPM model =

Risk-free return (Rf) + beta (β) × market risk premium (RPm)

The cost of equity could be simplified to be the opportunity cost associated with that money for the company if it decided to use that money for its normal activities.

In the event that the project is financed by a bank loan and by the owners' funds, a pro rata must be used according to the source of the funds.

Finally, one must calculate the present value of the individual cash flows and the net present value.

Let's assume that the company requires a minimum return on its investment of 5%, we will use this 5% as the discount rate.

For the previous example:

VAN = ( -1 500 000 ) / (1+5%) 0 + 100 000 / (1+5%)1 + 200 000 / (1+5%)2

350 000 / (1+5%)3 + 500 000 / (1+5%)4 + 850 000 / (1+5%)5

VAN = 156 335,63$

What does this amount represent?

The expected profit over a 5-year horizon, assuming that the value of money over time is depreciated at the rate of 5% per year.

If we had used another discount rate, for example 10%, the NPV result would have been: - $111,551.62

However, this does not indicate that the project is not profitable. It's about putting the company's performance goals into perspective. Over a 5-year horizon, taking into account that the value of money depreciates and that a return of 10% is required. This investment would be a ''No go'' because the NPV result is negative.

Title

It is important to assess to the best of your knowledge the value of future cash flows because these have a direct impact on the NPV, particularly during the first years.

In conclusion, the net present value makes it possible to evaluate the profitability of a project over a horizon of several years by taking into account a required return. Ratios and financial assessment tools are powerful tools for those who know how to interpret quantitative and qualitative results.