Net present value is a financial technique which uses a projects costs and returns over time to determine if the project will make a positive return.
Importantly it takes into account the time value of money – i.e. that a £ earned today is worth more than a £ earned a year from now. As projects often have lifespans of a number of years, it is important to understand how the costs and returns on a project vary over time and factor in the time value of money.
Let’s explain this by way of a simple example. A company must decide whether to approve a recently requested project. The project has the following cash flow profile.
- Cash outflow of £100,000 which is an up-front investment in the project.
- Years 1 – 6: Cash outflow of £5,000 per year
- Years 1 – 6: Cash inflow of £30,000 per year due to new revenue streams
- No further inflows or outflows after year 6.
We also need to consider what is called the discount rate – in simple terms the level of return we want to make on the money invested in the project. In the following example, the discount rate is 10%.
The sum of the present values is the net present value. As the NPV for the project is greater than zero, it would be better to invest in this project than do nothing.
Use NPV as a screening tool – not a prioritisation tool
In the project selection process, NPV is typically used to make screening decisions i.e. does this project make us money? Only projects that meet a certain level of return are considered further.
NPV cannot be used to prioritise or rank projects as the NPV of one project cannot be directly compared to that of another – a large project will probably have a bigger NPV than a smaller project, but require a bigger investment.
Making preference decisions i.e. choosing between different projects requires using a scoring model possibly combined with the profitability index of the project. The profitability index of a project is simply the present value of future cash flows / initial investment. The higher the profitability index, the more desirable the project.
Within iPlanWare, NPV can be easily calculated for projects and analysed across the portfolio.