How to Use Net Present Value While Evaluating Investments?
Every investment, be it personal finance or business, commands money. As an investor, it is crucial for you to understand if your investment is worth your money or not. This is where metrics like net present value (NPV) can help you.
What is Net Present Value?
Net present value, or NPV, is a financial metric through which you can assess the profitability of an investment. NPV factors in the future cash flow generation of an investment and adjusts it to its current value.
In other words, it tells an investment's worth today based on expected future returns after considering the time value of money. The time value of money means that money is worth more now than in the future due to its potential earning power with time.
Net Present Value Formula
Before getting into the nitty-gritty of the net present value method to evaluate investments, let’s see the net present value formula. The formula to compute net present value is:
NPV = Rt / (1+ i) t where
- Rt = net cash flow
- i= discount rate, i.e., the rate reflecting your desired return from your investment
- t= time of cash flow
A positive NPV shows that your investment is likely to generate more value than its cost and vice versa. When NPV is positive, it means a more profitable opportunity. Let’s understand the working of the net present value method with an example.
Suppose you wish to invest ₹5 lakhs in a business from which you expect to generate cash flows of ₹1.5 lakhs each year over the next five years (assuming a constant cash flow for calculation simplicity). You decide to use a discount rate of 10%. Using the net present value formula mentioned above, your NPV in the five years would be (see table):
| Year | NPV |
|---|---|
1 | ₹1,36,364 |
2 | ₹1,23,966 |
3 | ₹1,12,696 |
4 | ₹1,02,451 |
5 | ₹93,137 |
The addition of all the NPVs comes to ₹5,68,614. Upon subtracting the original investment amount, your NPV stands at ₹68,614. It means the investment is a profitable opportunity.
Benefits of Implementing the Net Present Value Method to Evaluate Investments
Using the net present value method offers several advantages. Some of them are as follows:
- Accounts for Time Value of Money
The net present value method accounts for the time value of money, thus giving you a clearer picture of the profitability of your investment.
- Factors in All Cash Flows
The net present value formula accounts for every cash flow you expect from your investments. This provides a complete overview of the return potential.
- Flexible and Adjustable
You can adjust the discount rate in the net present value formula to test different scenarios and see how changes in interest rates impact your investments.
Limitations of Net Present Value Method
The net present value method also has certain limitations. These are:
- Accurate Prediction of Future Cash Flows
The success of the net present value method depends on the accuracy of your prediction of future cash flows. Any error on that front could lead to inaccurate results.
- Choosing the Right Discount Rate
Zeroing in on the discount rate could be challenging. Even the minutest of changes can impact the result.
- Can Lead to Complexity
The calculation could be complex and challenging for investments with multiple cash flows and different time periods.
Summing it Up
While using the net present value formula and method can be a prudent way to gauge investment profitability, its success hinges largely on how accurately you can predict cash flows and discount rates. Combine it with other metrics to get a well-rounded view of your investment’s potential.
Disclaimer: This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.
Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Please read the SEBI-prescribed Combined Risk Disclosure Document before investing. Brokerage will not exceed SEBI’s prescribed limit.
