What is Net Present Value? Money in hand is more valuable than what you will receive in future. Simple logic. You can invest the money to earn returns/interest. Money that you will receive in future is less valuable because inflation would erode its value over time. So, how do you compare money today vs money that you will receive in future? That is what Net Present Value (NPV) would cover.
Net Present Value – Definition
NPS allows you to compare your investment options against your opportunity cost. Opportunity cost is the interest you stand to lose if you choose one option over the other. For example, you can keep Rs 10 lakh in a bank FD and safely earn a return of 6% p.a. after taxes. Here if you want to invest Rs 10 lakhs anywhere else, your opportunity cost is 6% p.a.
Thus, if you want to invest the same amount in a mutual fund with a higher risk profile, you would want the mutual fund to offer you better returns than 6% p.a. NPV gives you the difference between your current value of an investment and the money received in future. This is the most simplistic definition of NPV. It is a method of analysing whether a particular project or investment is worth considering.
If the NPV is positive, that means your new investment offers you better than the opportunity cost. If not, there is no motivation for you to leave the safety of fixed deposits (or your current investment).
How to Calculate NPV using Formula?
To calculate NPV, you must know the timing of the future cash flows. You will discount the future amount to today’s value using the rate of return, called the discounting rate.
NPV = Net Present Value
a0 = initial investment amount (represented as negative cashflow)
an = cash flow at time n
i = discount rate for the period
n = time of the cash flow
t = total number of cash flows
As long as interest rates are positive, a rupee today is worth more than a rupee in the future. This is because inflation would erode the value of the same rupee.
For example, if you are offered Rs 100 today vs Rs 100 a year later. Availing it today is sensible because the same Rs 100 cannot buy the same goods a year later. After all, the goods would become costlier due to inflation.
However, if you invest Rs 100 in inflation-beating financial instrument, your money would be more valuable in future. So, the discount rate is critical for NPV calculation.
How to Calculate NPV Using MS Excel?
The Excel NPV function calculates the net present value (NPV) of an investment using a discount rate and future cash flows.
= NPV (rate, v1, [v2], ...)
- rate - Discount rate over one period.
- v1 - First value(s) representing cash flows.
- v2 - [optional] Second value(s) representing cash flows.
When to Use NPV?
NPV can come in handy when planning your investments across asset classes and financial instruments. For example, if you are comparing instruments with recurring deposits such as PPF, NPS, ULIP, ELSS SIP etc, NPV is the perfect tool to evaluate returns.
For example, you are evaluating a 3-year bank deposit that pays interest each month and comparing this with a stock that you will be selling off after 3 years. Calculate the NPV of both these options using the rate of inflation as the discounting rate and invest in whichever has a higher NPV.
Advantages and Disadvantages of NPV
NPV is a good method to understand if the new investment will meet your ROI expectations. However, it suffers from disadvantages in certain situations:
|Uses time value of money||No set guidelines for the rate of return|
|Simple, easy way to evaluate projects||Can’t compare projects of different sizes|
|Considers cost of capital||Does not consider the cashflow size|
|Factors in uncertainty by discounting far-future estimates||Does not consider qualitative factors|
|Possible to consider ROI changes over time||Difficult to compare investments with different tenures|
Alternatives to NPV
NPV estimates how valuable your project is in comparison to another project (or investment) with similar value. However, NPV is not an all-pervasive method of investment evaluation. Some alternative methods to NPV are:
a) Payback Period
The payback method is a viable alternative to NPV and calculates how long it will take for you to recover your money. The formula is simple to remember and calculate. You need the initial investment and the net annual cash flow to calculate the payback period.
The formula for calculating the payback period is:
Payback Period = (Initial Investment / Average Annual Cash Inflow)
The payback method helps in quickly evaluating projects and reducing the risk of losses. A project with a short payback period is efficient and improves liquidity. It implies the project is less risky and helpful for small enterprises with restricted resources. A smaller payback period also reduces the risk of losses caused due to changes in the economy.
b) Internal Rate of Return (IRR)
The IRR is arrived at by finding out the discount rate needed to make NPV zero. IRR method is used to evaluate projects of different tenures basis their rates of forecasted return.
For example, Comparing the projected profitability of 3-year and 10-year projects. NPV calculates the total amount of money you will make in an investment, factoring in the time value of money. In IRR, you calculate the annual rate of return that you would earn.
Which Method should you Use with Investments?
While NPV is a good method to evaluate your investments, its use requires an understanding of the following factors:
- Expected ROI or Opportunity cost
- Future cash flows
Thus, NPV is good for evaluating investments like Monthly Income Plans (MIPs) or market-linked investments which generate income. For example, in ULIPs like Invest 4G from Canara HSBC Life Insurance, you can invest up to the age of 99. This allows you to build a corpus by the age of 60 and then use it to draw a pension for life.
If you want to assess if you should stay invested or withdraw from the ULIP to invest elsewhere, you can use the NPV method to compare incomes.
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Evaluate your Investment Options
NPV determines how much an investment, project, or cash flow is worth. It is a comprehensive metric because it accounts for revenues, expenses, and capital costs associated with the investment. In addition, it also accounts for the timing of each cash flow that impacts the present value of an investment. Payback and IRR are alternatives to NPV although each has its respective advantages and drawbacks.
However, evaluating your investment options is more important than the methods. You should evaluate your investments before investing and after investing money.Disclaimer: This article is issued in the general public interest and meant for general information purposes only. Readers are advised to exercise their caution and not to rely on the contents of the article as conclusive in nature. Readers should research further or consult an expert in this regard.