Net Present Value Planning and Control

Determining if a project is worth proceeding with or abandoning can be a dificult decision and one that all business managers should not make lightly. How do you know if that investment is viable and will provide the return to make it profitable?

Financial staff typically use one or both of the following methods to project cash flow. The first Method is the use of "Net Present Value" (NPV). The other is the use of the "Internal Rate of Return" (IRR). NPV is an indicator of how much value an investment or project adds to the company. It is used to calculate how much a $1 invested today is worth in the future.

Using the NPV for the selection of a project, the projects net cash flows are discounted at the minimum amount required rate of return. An acceptable project is then simply one that offers a positive NPV. Using the IRR for the project selection requires the net cash flow to return a NPV of 0. This discount rate is the projects IRR, a good project is one with an IRR that exceeds the required rate of return.

Net Present Value

The value of capital at different time lines can be assessed using exchange rates. Let us look at an example.

We value $1000 now as $1050 this time next year. This assumes a rate of  5%. This 5% is now our "marginal investment rate" (MIR). That is to say that to get $1050 next year we would need to invest $1000 now at a MIR of 5%.

Inversely, the $1050 has a "present value" of $1000.

We can say $1000/$1050 becomes  1/1.05  and becomes our working ratio. In subsequent years, assuming the ratio is stable, we simply multiply the result with the ratio over and over again as necessary. For example, we want to know the present value of a $3000 dollar return we would get in 3 years time.

$3000 x (1/1.05) x (1/1.05) x (1/1.05) = 

$3000 x .952 x .952 x .952 = $2588.40

This means that we would need to invest $2588.40 now, at 5% to get a return of $3000 in 3 years from now.

Applying this concept to a project you can determine if the investment now will provide you with the return that you wish to achieve in the future.

It is important for companies to know what their Internal Rate of Return is so that they can quickly determine in an investment will yield the right results. Most sales people will quote Return on Investment (ROI) this is a very simple way to check one investment against the other, the higher the rate of ROI the better the investment. It is calculated by the expected return (gain less cost)divided by the cost and is normally read as a percentage.

Although ROI will tell you whether an investment will create a good return or not, you need to determine if it will create a higher return than investing the money elsewere, like securities. This is where IRR is used to evaluate if the investment's return is worthwhile pursuing. Further evaluation can be made with NPV to work out if what sounds like a lot of money in the future is worth the same now.

Being armed with this information can be very powerful knowledge, aprticularly if seeking financial assistance from a loan or an investor. Being able to show the return of the investment can make all the difference between success of failure.