The Net Present Value (NPV) method is a discounted cash flow technique used in capital budgeting. It recognizes time value of money. Under this method, the present value is determined by discounting the future cash flows of a project at a predetermined (cut-off) rate. This cut-off rate is based on the cost of capital.
Determination of NPV
The present value can be determined by the following formula:
PV=1/(1+r)n
Where, PV= Present value
r= rate of interest
n= number of years
The present value of all the cash inflows for a number of years can be determined by the following formula:
NPV= -Po + P1/(1+r) + P2/(1+r)2 + P3/(1+r)3 + …………….+ Pn/(1+r)n
Where,
P1, P2, P3, …… Pn= Future net cash inflows
r = Rate of interest
2,3,4,……. and n = number of years
In order to determine the NPV, first we have to select an appropriate rate of interest as the minimum rate of return. This rate is also called cut-off rate or discount rate. It may be the actual rate of interest prevailing in the market on long-term deposit or any other rate reflecting the opportunity cost of capital to the investors. After finalising the cut-off rate, we have to determine the present value of total cash outflows and total cash inflows relating to the project at the predetermined cut-off (discount) rate. If total cash outflows are made in the initial year, then the present value would be equal to the initial cash outflows. After subtracting the present value of cash outflows from the present value of cash inflows we will get the net present value for the project. If the net present value is positive (i.e., NPV>0) then the project should be selected. If the net present value is negative (i.e., NPV<0) then the project may be rejected.
Conclusion
The net present value method takes into account the market rate of interest or cost of capital. It also recognises the time value of money. This method is useful in both the cases whether cashflows are even or uneven at different periods of time. It considers the earnings of the project for its entire economic life which in turn enables evaluation of true profitability.