MSG Team's other articles

12099 Why Financial Innovation can be both a Force for Good and Bad ?

Exotic Innovations or Weapons of Mass Destruction ? Anybody who has followed the severe and protracted financial crises of the last Eight years would be aware of the damaging role played by Exotic Financial Products such as Derivates, Swaps, Credit Default Swaps, and Options. These instruments that are supposedly in place to hedge against risk […]

8995 Dividend Discount Valuation: H Model

The dividend discount model makes a lot of assumptions. Some of these assumptions are not considered to be viable by analysts. For instance, consider the assumption regarding growth rates. During the horizon period, the analyst estimates that the growth rate will be high, let’s say 10% or 12%. Then, when the terminal value is to […]

11765 Variations in Cash Flow Models

We are now aware of how to use the basic single stage models for both free cash flow to the firm (FCFF) and free cash flow to equity (FCFE). It is now time to look into more advanced models which involve two or more stages for which cash flows will be predicted. Now, we need […]

9637 How Investment Bankers Help Promoters Retain Control?

Companies want to go public because it helps them raise cash, which can be used for further expansion. However, the promoters of these companies often do not want to go public since this would mean that their stakes would be diluted and that they would lose control over the company. A low promoter’s stake in […]

12422 Advantages of Behavioral Finance

The problem with traditional financial theories is that they tend to operate in an ideal world! The underlying assumptions are that the information available is perfect, the investors are capable of interpreting the information. Another assumption is that there is a single right answer which can be mathematically worked out. However, when investors use this […]

Search with tags

  • No tags available.

The net present value (NPV) is the most important concept in corporate finance. It is on the basis of this concept that investment decisions are made or not made. It is on the basis of this concept that stocks and bonds are valued. Thus, it is an absolute imperative for any student of corporate finance to be thoroughly well versed with this concept. One needs to have a fair understanding of future and present value calculations to understand the net present value concept. The NPV is best understood with the help of a cash flow timeline. This article will use the same to explain it:

The Cash Flow Timeline:

Cash Flow Timeline

The cash flow timeline is a representation of the periods when cash is expected to be paid or received during the project. Point Zero, represents today. Hence all the amounts listed in point Zero are present values. We do not have to adjust them by compounding or discounting for the net present value calculations.

The values listed under point 1 are the amounts that will be received or paid at the end of period one. The values listed under period 2 are the amounts that will be received or paid at the end of period 2, so on and so forth.

Future Values Occur In Different Periods

When we compare two numbers, we must ensure that that are of similar nature. Hence, when comparing cash flows we must ensure that all of them are either present values or future values belonging to the same future period. Comparing a present value to a future value or comparing a future value in period 1 to a future value in period 2 is like comparing apples to oranges.

Since future values all occur in different periods, we cannot compare them with each other. The only way to add or subtract these values is if we bring them all back to day zero i.e. convert every future value to their equivalent present values.

Present Values Occur at the Same Time i.e. Day Zero

Since present values depict the value of money on day zero i.e. in the same period, it would be correct for us to add, subtract or perform any other mathematical operation on this number. The key point to understand is that all values involved in the calculation must be present values.

NPV Calculation Example

Let’s consider the following schedule of cash outflows and inflows:

    Period 0: $10,000 Cash Outflow

    Period 1: $5,000 Inflow

    Period 2: $4,000 Inflow

    Period 3: $3,500 Inflow

    Period 4: $3,000 Inflow

Cost of Capital is 10%.

The question is whether it is financially wise to invest $10,000 today and receive 4 installments of $5000, $4000, $3500 and $3000 if our cost of capital is 10%.

Solution:

Outflow: $10,000

Present Value of Inflows: PV (Inflow in Year 1) + PV (Inflow in Year 2) + PV (Inflow in Year 3) + PV (Inflow in Year 4)

    = ($5,000/1.1)1 + ($4,000/1.1)2 + ($3,500/1.1)3 + ($3,000/1.1)4

    = $4,545.46 + $3,305.79 + $2,629.60 + $2,049.04

    = $12,529.89

Net Present Value = Present Value of Inflows – Present Value of Outflows

    = $12,529 - $10,000

    = $2,529

Net Present Value Rule

The net present value rule states that if the NPV of the proposal is greater than 0, it must be accepted. For less than and equal to zero the proposals must be rejected. In this case, the NPV is $2529. Hence, this proposal is financially sound given the cost of capital of the firm. It would be in their best interest to accept this proposal.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

What is Cost of Equity? – Meaning, Concept and Formula

MSG Team

Cross Border Credit Reporting

MSG Team

What is Corporate Finance? – Meaning and Important Concepts

MSG Team