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Net Present Value Method<\/h3>\n\n
The time value of money is an important element we must consider as a part of capital budgeting, recognizing that cash flows early will be worth more early on than those occurring later. <\/p>\n\n
Click through the pages to review the elements of this topic.<\/p>\n","coverMedium":{"params":{"decorative":true,"contentName":"Image","expandImage":"Expand Image","minimizeImage":"Minimize Image","title":"Photo by Pietro Jeng on Unsplash","file":{"path":"images\/file-6633b74e40bb7.jpg","mime":"image\/jpeg","copyright":{"license":"U"},"width":5616,"height":3744}},"library":"H5P.Image 1.1","metadata":{"contentType":"Image","license":"U","title":"Untitled Image"},"subContentId":"316910e4-5b84-4562-9608-002cf62407c2"}},"chapters":[{"params":{"content":[{"content":{"params":{"text":"
The time value of money is an important element we must consider as a part of capital budgeting, recognizing that cash flows early will be worth more early on than those occurring later.  <\/p>\n\n
Techniques that consider both the time value of money and estimated net cash flow of an investment are called discounted cash flow techniques. These techniques are recognized as the best way to make capital budget decisions, helping to determine whether or not a company should invest in a specific project.  <\/p>\n\n
Using this method, the expected net cash flow used in discounting cash flows consist of: <\/p>\n\n
Net Annual Cash Flows + Estimated Liquidation proceeds (salvage value) \u2192 when sold at the end of its life. <\/strong><\/p>\n\n
The most commonly used technique is the net present value method (NPV), which involves discounting net cash flows to their present value and then comparing this current day value with the capital costs associated with the investment. The difference between the two amounts provided is the NPV. A proposal is acceptable when the net present value is zero or positive. The greater the positive amount of the NPV, the more attractive the investment.  <\/p>\n\n
= If 0 or + = accept <\/strong><\/p>\n\n
Present Value of Net Cash Flows - Capital Investments = NPV =   If negative = reject <\/strong><\/p>\n\n
\n
In order to use the NPV method, an interest rate will need to be determined by management in order to discount future net cash flows - this is called the discount rate or required rate of return <\/span><\/em><\/p>\n\n
\n
The NPV can be applied in two cases: <\/strong><\/h3>\n\n
1. Equal annual cash flows <\/p>\n\n
As outlined in the above case, the net annual cash flow is $50K ($300k-250k). If it is assumed to remain constant throughout the asset\u2019s useful life, we would calculate the current day value of the net annual cash flows by using the present value of an ordinary annuity of 1 for 12 periods. Assuming a discount rate of 15% and using Table 4 in Appendix 13A (added below), the present cash flow is calculated. <\/p>\n\n
NOTE: See Formula from Table 4 in Appendix 13A and table for reference<\/span><\/em><\/p>\n\n
                                                                    Present Value at 15% <\/strong><\/p>\n\n
Discount Factor for 10 periods                           5.42062 <\/strong><\/p>\n\n
Present Value of Net Cash Flows <\/strong><\/p>\n\n
$50,000 x 5.42062                                           $271, 031 <\/strong><\/p>\n\n
<\/p>\n\n
                                                                          15%  <\/strong><\/p>\n\n
Present value of net cash flows                        $271,031 <\/strong><\/p>\n\n
Capital Investment                                            $500,000 <\/strong><\/p>\n\n
Net Present Value                                             -$228,969 <\/strong><\/p>\n\n
The proposed capital expenditure is not acceptable as the required rate of returns of 15% at net present value is negative, indicating that the expected return on investment does not exceed 15%. However, if management were to lower their discount rate, this project may be viable. <\/p>\n\n
2. Unequal annual cash flows <\/h3>\n\n
The approach is not as straightforward when net annual cash flows are unequal - we cannot use the same annuity tables to calculate the present value. In the case of unequal annual cash flows, we must showcase the present value for each single future amount and apply it to each annual cash flow.  <\/p>\n\n
Let\u2019s use a different case, where the expected total net cash flow of $186,000 over the life of this investment but there is a declining market demand over the life of the equipment (and it has a shorter lifespan of 5 years). Let\u2019s say the initial capital investment was $125,000 and the discount rate was 10%. <\/p>\n\n\n\t\n\t\t\n\t\t\t\n\t\t\t
Year <\/strong><\/p>\n\t\t\t\n\t\t\t\n\t\t\t
Assumed Net Annual Cash Flows (1) <\/strong><\/p>\n\t\t\t\n\t\t\t\n\t\t\t
Discount Factor 10%  <\/strong><\/p>\n\n\t\t\t
(2) <\/strong><\/p>\n\t\t\t\n\t\t\t\n\t\t\t
Present Value 10% <\/strong><\/p>\n\n\t\t\t
(1x2) <\/strong><\/p>\n\t\t\t\n\t\t\n\t\t\n\t\t\t\n\t\t\t
1 <\/p>\n\t\t\t\n\t\t\t\n\t\t\t
50,000 <\/p>\n\t\t\t\n\t\t\t\n\t\t\t
0.90909 <\/p>\n\t\t\t\n\t\t\t\n\t\t\t
$45,454.50 <\/p>\n\t\t\t\n\t\t\n\t\t\n\t\t\t\n\t\t\t
2 <\/p>\n\t\t\t\n\t\t\t\n\t\t\t
45,000 <\/p>\n\t\t\t\n\t\t\t\n\t\t\t
0.82645 <\/p>\n\t\t\t\n\t\t\t\n\t\t\t
$37,190.25 <\/p>\n\t\t\t\n\t\t\n\t\t\n\t\t\t\n\t\t\t
3 <\/p>\n\t\t\t\n\t\t\t\n\t\t\t
36,000 <\/p>\n\t\t\t\n\t\t\t\n\t\t\t
0.75132 <\/p>\n\t\t\t\n\t\t\t\n\t\t\t
$27,047.52 <\/p>\n\t\t\t\n\t\t\n\t\t\n\t\t\t\n\t\t\t
4 <\/p>\n\t\t\t\n\t\t\t\n\t\t\t
28,000 <\/p>\n\t\t\t\n\t\t\t\n\t\t\t
0.68301 <\/p>\n\t\t\t\n\t\t\t\n\t\t\t
$19,124.28 <\/p>\n\t\t\t\n\t\t\n\t\t\n\t\t\t\n\t\t\t
5 <\/p>\n\t\t\t\n\t\t\t\n\t\t\t
27,000 <\/p>\n\t\t\t\n\t\t\t\n\t\t\t
0.62092 <\/p>\n\t\t\t\n\t\t\t\n\t\t\t
$16,764.84 <\/p>\n\t\t\t\n\t\t\n\t\t\n\t\t\t\n\t\t\t
<\/p>\n\t\t\t\n\t\t\t\n\t\t\t
186,000 <\/p>\n\t\t\t\n\t\t\t\n\t\t\t
<\/p>\n\t\t\t\n\t\t\t\n\t\t\t
145,581.39 <\/p>\n\t\t\t\n\t\t\n\t\n\n\n
                                                            10% <\/strong><\/p>\n\n
Present value of net cash flows      $145,581.39 <\/strong><\/p>\n\n
Capital investment                          $125,000 <\/strong><\/p>\n\n
Net present value                           $20,581.39 <\/strong><\/p>\n\n
In this case, the present value of the net cash flow is greater than the original $125,000 investment. Therefore, the project proposed is acceptable at a 10% discount rate. As more money is received early on in the project (net annual cash flow is highest in those early years), it leads to greater present day values.  <\/p>\n"},"library":"H5P.AdvancedText 1.1","metadata":{"contentType":"Text","license":"U","title":"Untitled Text"},"subContentId":"19801f4c-efeb-486f-8476-38cb00b5e6c3"},"useSeparator":"auto"}]},"library":"H5P.Column 1.18","metadata":{"contentType":"Column","license":"U","title":"Net Present Value Method"},"subContentId":"da354483-077a-466b-a039-861bdf0c0f19"},{"params":{"content":[{"content":{"params":{"media":{"disableImageZooming":false},"taskDescription":"Drag the words into the correct boxes","overallFeedback":[{"from":0,"to":100}],"checkAnswer":"Check","submitAnswer":"Submit","tryAgain":"Retry","showSolution":"Show solution","dropZoneIndex":"Drop Zone @index.","empty":"Drop Zone @index is empty.","contains":"Drop Zone @index contains draggable @draggable.","ariaDraggableIndex":"@index of @count draggables.","tipLabel":"Show tip","correctText":"Correct!","incorrectText":"Incorrect!","resetDropTitle":"Reset drop","resetDropDescription":"Are you sure you want to reset this drop zone?","grabbed":"Draggable is grabbed.","cancelledDragging":"Cancelled dragging.","correctAnswer":"Correct answer:","feedbackHeader":"Feedback","behaviour":{"enableRetry":true,"enableSolutionsButton":true,"enableCheckButton":true,"instantFeedback":false},"scoreBarLabel":"You got :num out of :total points","a11yCheck":"Check the answers. The responses will be marked as correct, incorrect, or unanswered.","a11yShowSolution":"Show the solution. The task will be marked with its correct solution.","a11yRetry":"Retry the task. Reset all responses and start the task over again.","textField":"The time value of money is an important element we must consider as a part of capital budgeting, recognizing that cash flows early will be worth more early on than those occurring later.\u00a0\u00a0\n\nTechniques that consider both the time value of money and estimated net cash flow of an investment are called discounted cash flow techniques. These techniques are recognized as the best way to make capital budget decisions, helping to determine whether or not a company should invest in a specific project."},"library":"H5P.DragText 1.10","metadata":{"contentType":"Drag the Words","license":"U","title":"Untitled Drag the Words"},"subContentId":"df040cc7-f882-4d8f-9d0f-936d231725f4"},"useSeparator":"auto"}]},"library":"H5P.Column 1.18","metadata":{"contentType":"Column","license":"U","title":"Check for Understanding"},"subContentId":"c6692316-2273-419c-8dbd-f516436fc554"}],"behaviour":{"baseColor":"#1768c4","defaultTableOfContents":true,"progressIndicators":true,"progressAuto":true,"displaySummary":true,"enableRetry":true},"read":"Read","displayTOC":"Display 'Table of contents'","hideTOC":"Hide 'Table of contents'","nextPage":"Next page","previousPage":"Previous page","chapterCompleted":"Page completed!","partCompleted":"@pages of @total completed","incompleteChapter":"Incomplete page","navigateToTop":"Navigate to the top","markAsFinished":"I have finished this page","fullscreen":"Fullscreen","exitFullscreen":"Exit fullscreen","bookProgressSubtext":"@count of @total pages","interactionsProgressSubtext":"@count of @total interactions","submitReport":"Submit Report","restartLabel":"Restart","summaryHeader":"Summary","allInteractions":"All interactions","unansweredInteractions":"Unanswered interactions","scoreText":"@score \/ @maxscore","leftOutOfTotalCompleted":"@left of @max interactions completed","noInteractions":"No interactions","score":"Score","summaryAndSubmit":"Summary & submit","noChapterInteractionBoldText":"You have not interacted with any pages.","noChapterInteractionText":"You have to interact with at least one page before you can see the summary.","yourAnswersAreSubmittedForReview":"Your answers are submitted for review!","bookProgress":"Book progress","interactionsProgress":"Interactions progress","totalScoreLabel":"Total score","a11y":{"progress":"Page @page of @total.","menu":"Toggle navigation menu"}}