What is NPV and what does it represent?

Have you ever think about how to analyze whether a project is worth it or not from a financial point of view? How to do this analysis effectively? Well, for this there are several methods of economic feasibility analysis that can help you in this task and among them is the Net Present Value (NPV). But what is NPV?

To understand NPV, we must first learn the concept of the hurdle rate. The hurdle rate is basically a discount rate that represents the minimum return that the investor wants to get on a project. Now that you know this, we can go back to the NPV.

What is NPV?

NPV can be defined as the present value of future payments by discounting the cost of capital rate. Okay, but what is this? Well, imagine that you intend to do a 5-year financial project. To find the NPV, we have to project what the cash flows from these 5 years will be and discount the hurdle rate.

So the NPV seeks to bring into the present what the cash flows of that investment will be. Making this investment today, I know that in year ONE it will bring a real X return, in year TWO, real Y and so on.

Given this, we bring these returns or cash flows into the present, that is, to how much this money is worth today. Then we will use the selection criterion associated with the NPV to indicate the feasibility of the investment project.

What is NPV for?

The Net Present Value is used to measure the economic feasibility of a project, being one of the most reliable and practical methods for this type of analysis. When compared with other methods of analysis, this method stands out from the economic point of view.

Okay, but how to use the NPV to tell if the project is workable or not? Well, if the hurdle rate equals to the investor's expected rate of return and the NPV is positive, the project will be classified as viable. If we obtain a negative NPV it means that this investment is not viable. But why?

If the NPV is greater than zero, it means that this project has value, that is, it brings a return to the investor, generating profit. In contrast, if the NPV is less than zero, the project does not bring a return to the investor, generating a loss. This will be better understood when we perform the calculations in the example we brought to you.

How to calculate NPV?

To calculate NPV, we use the following formula which is used for both uniform and nonuniform cash flows.

Although the NPV formula is difficult to understand, it can be easily calculated with a financial calculator or even a scientific calculator. The most important thing is to understand the concept employed in the formula.

Each tranche represents the cash flow of each project year, i is the hurdle rate and t ranges from 0 to n. The first term represents the initial investment of the project, and therefore, its input is negative.

It is based on this calculation that we will say whether the investment is viable or not, considering the result being subject to some analysis that we will do later. Got confused? Calm down, an example will help you understand.

Example of NPV calculation

Let's imagine that our 5-year project needs an investment of R $ 230,000.00, occurring on date zero. Once the analysis has been completed, we conclude that we will have an annual cash flow of R $ 65,000.00 and stipulate a hurdle rate of 10% per year. We must decide whether the project should be accepted or not.

By doing the calculations we obtain the following table for each term:

Adding the parts we have:

NPV = -230.000 + 59.090 + 53.700 + 48.800 + 44.400 + 40.300 = 16.290

We have a NPV = R$ 16,290. This means that our investment is viable. If we had considered an analysis period of 4 years instead of 5, we would have a negative NPV, as we can easily conclude by looking at the table.

This variation caused by the analysis period is one of the key points to be taken into account in the use of this method of economic feasibility analysis.

Advantages and disadvantages of NPV

Throughout the calculations and explanations of NPV concepts, we can see some advantages and disadvantages. Therefore, we must take into account the characteristics of the project to decide which method to use.

The NPV is indicated when we want to generate cash flow, having advantages in relation to this, for example, the fact of considering the value of money over time. In addition, it takes into account the cost of capital of the company, in the form of the hurdle rate.

However, NPV has its disadvantages. One of these is the requirement that the investor accurately predicts future cash flows, which requires knowledge of various financial parameters and indicators.

Another disadvantage of the Net Present Value is that it disregards the project life. That is, projects with a longer duration will tend to have a higher NPV, even if it is not really the best option.

We should also note that projects with a large initial investment tend to have a higher NPV than projects with lower investments, even if these projects are not better if we analyze them in relative terms, the NPV can lead to the error.

Despite these disadvantages, when it comes to analyzing a project from an economic standpoint, NPV is one of the best existing methods an investor can use to know the feasibility of their investment.

Conclusion

Understanding what NPV is and what it represents is very important to any investor as it is one of the most widely used economic feasibility analysis methods.

You must have realized that much more important than performing the calculation, is knowing how to interpret the concepts, analyzing the obtained result. To calculate, we can use tools like Microsoft Excel, for example, that will make this task simple and fast.

As we have seen, you must be careful not to fall into the traps that a careless analysis can create. Considering this, the use of the Net Present Value will certainly help you to choose the best investment, with a focus on generating the largest possible cash flow.

It is worth remembering that the NPV can also be used to measure the feasibility of launching a new product, such as a new computer, for example. All these characteristics make NPV an excellent choice when deciding whether a project should be accepted or not, right?

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