Net present value. Present value

In modern economic terminology, it is quite often possible to find such term as "net present value", meaning the calculated value, which is used when comparing different investment options.

One of the most important and common decisions taken by business entities is the issue of investment in other enterprises. So, every year millions of rubles are invested in factories or their equipment, which will function and bring additional profit for many decades. The flow of cash in the future, which can bring investment, often differs in some uncertainty. And if plants or factories are already built and do not bring the expected profit, then the investor will no longer be able to disassemble them and resell them in order to compensate investments. In this case, the business entity (investor) bears irretrievable losses.

Terminology

The net present value characterizes the current amount of cash resources needed to generate a future income equivalent to its counterpart received from the implementation of a particular investment project. For example, there is a deposit rate of 10%, then 100 rubles will bring 110 rubles at the end of the year. From the position of the analysis of economic efficiency from the contribution of 100 rubles to the deposit or to the investment project, which can bring the same 110 rubles, the present value will be the same.

There is still an index of profitability of the investment project - this is the result of dividing the net present value by the total amount of discounted investments (investment costs).

Determining the appropriateness of investments

When accepting an investment project for more than one year, the benefits from such investments can be determined by bringing the future received funds at the end of the year to the start date of the project. This determines the net present value, which should "return" to the investor. This amount is compared with the projected costs, however, in carrying out such an assessment, it is necessary to take into account the "underwater stone" in the form of interest capitalization. That is, the dividends are paid to the investor once, at the end of the year, but the bank can pay interest monthly. That is why the net present value in conducting a comparative analysis is determined by different formulas, and in the case of a financial institution, it is necessary to take into account the monthly capitalization of interest on the deposit.

In the economic literature, one can also find such an "academic" formulation: the net present value of an investment project is a positive balance of financial resources received by all monetary receipts and expenditures. Its amount is reduced to the initial time (the date of the beginning of the implementation of the investment project).

The result shows the amount of money that an investor can receive after the project is implemented. Often, the current value reflects the overall profit of the investor, but in this case the residual value of the project itself should not be taken into account.

Net present value of the project: calculation formula

So, when calculating this indicator, the following formulas are used:

• NPV = SUM (CF _t / (1 + i) ^t );
• NPV = -IC + SUM (CF _t / (1 + i) ^t ),

Where:

T is the number of years;
CF - payment through t-years;
IC - invested capital;
I is the discount rate.

Factors of discounting

The net present value can be reliably determined only if the discount rate is correctly selected. Based on the value of this indicator, it is possible to find the corresponding coefficients for the period for which the analysis is carried out.

Only as a result of the determination of the value of revenues and the costs of cash flows, the net present value can be determined as the difference between these two values. As a result, this indicator can be both positive and negative.

Let us dwell in more detail on its meanings:

• A positive value will show that in the calculation period, cash receipts in discount terms will exceed the same amount of investment, and this contributes to the value of the business entity;
• A negative value shows the absence of the desired rate of profit, which leads to certain losses.

Consideration of alternative investment options

Often, investors before investing their own funds in a particular project ask themselves the question: what discount rate should be used by the company when calculating net present value? The answer depends on the availability of alternative investment opportunities. For example, sometimes, instead of a certain investment investment option, an enterprise uses its financial resources to acquire a different kind of capital that can bring in more profit. Either the business entity acquires bonds, which are characterized by a guaranteed availability of its own profitability.

Investments with equal risk levels

There is such a thing as "similar" investments. These are investments that have an equal level of risk. From the theory it is known that the higher the risk of investment, the higher the level of income, and accordingly, the net present value. Therefore, alternative investment in this project is an income for which it is probable that it will be received in the same amount as the investment in another project or an asset with the same level of risk.

To assess the degree of investment risk, it is necessary to assume the existence of a project that is not associated with any risk. Then, as an alternative cost of investment, a risk-free income is assumed. An example of such income is the purchase of government bonds. When calculating the project for ten years, the business entity will be able to use the annual interest rate for the relevant government bonds.

Summarizing the material presented, it should be noted that this economic indicator quite successfully helps the investor in determining the feasibility of investing free funds in a particular production.