Making Sense of your Project’s NPV
 

Net Present Value (NPV) is one of the most important, if not the most important, financial measurement used when evaluating projects. NPV calculates the amount of money, in today’s dollars (or Euros, Yen, etc.), that a project is expected to make (or lose) for a company. Let’s see why it’s important to calculate the amount of money in today’s dollars. Would you rather have a dollar today or one tomorrow? Think about it. If you said today, bravo! A dollar is worth more today than it will be tomorrow. Conversely, a dollar today is worth less than it was yesterday. Let’s see why…



A dollar today is worth more than at any point in the future due to inflation and interest rates. Inflation is the general increase in prices (we don’t like high inflation). The value of money depreciates as time goes by as a result of a change in the general level of prices. Changes in the price level are reflected in interest rates (we like high interest rates when we are investing our money).  Let’s look at an example to show how a dollar today really is worth more than one tomorrow.  If you have $1,000 tucked under your mattress and do nothing with it for a year, the value of that $1,000 declines due to inflation and the interest you could have earned on it if you invested it. If you deposited that money into an investment account, however, that earns 10% interest, the bank pays the interest and you would have $1,100 in a year. So stop stuffing all that money under your mattress! A dollar loses value over time due to inflation and interest rates that could be earned on it.


NPV takes forecasted cash flow streams (money either coming into the organization or going out) from your project investment and discounts them (compound interest in reverse) to the present day. Future cash flow streams are discounted to present day amounts to allow for better understanding of what all those future cash flow streams amount to. Also, it allows for true comparisons of competing project solutions that have different time periods for their forecasted cash flow streams. For instance, if one project solution has cash flow streams going out 3 years and another solution 5 years, the only way to do a true comparison is to discount them to today’s dollars. NPV makes it a true apples to apples comparison! The figure below illustrates how future cash flow streams are discounted back to the present day to determine NPV.


The NPV calculation does not deal in percentages, abstract numbers or ambiguous terms; it states, in hard cash, how much money a business will make or lose as a result of a project. If the NPV is positive, the company will make money, if it is negative the company will lose money, and if it is zero, the company will neither make nor lose money, but will cover the total costs of the project and break even. NPV is paramount in determining the attractiveness and viability of projects and must become a standard measurement tool for your organization in the project selection process.

NPV is valuable because companies will know the amount of money that is expected to be generated (or lost) and returned to the company’s cash reserves. Money that is generated can then be used for some very important business matters:

• Pay shareholders
• Reduce debt
• Re-invest in other projects
• Re-invest in other business initiatives

The formula for NPV is as follows:

NPV = CF (year 0) / (1 + r)⁰+ CF (year 1) / (1 + r)¹+ CF (year T) / (1 + r)^T

Where:
CF = Cash Flow (positive or negative)
r = Discount Rate (the rate at which future cash flow streams are discounted)
T = Number of time periods (usually in years) of the useful life of a project (total time period of the cash flow model)

But, thank goodness for Excel: =NPV(r, H1:H6).  H1:H6, in this example, is simply the rows depicting the 5 time periods (usually in years) of cash flows.

Go ahead and dust off an existing business case cash flow model and see how NPV was calculated. Adjust the numbers and see how that impacts the NPV.

For information on how we can assist you with your most challenging projects and training needs, visit us at www.reschgroup.com or give us a call at 1-201-803-4653.