# Net Present Value

## Contents |

# [edit] Introduction

The term ‘**Net Present Value**’ (NPV) represents the difference between the present value of cash inflows and the present value of cash outflows for an investment. It is used when considering capital investments to assess profitability.

For an investment to be worthwhile it has to yield a positive NPV, meaning that profit will be generated over time as a result of the investment. A negative NPV indicates that the investment is likely to lose money. Like any other business investment, property development will aim to yield a positive NPV that is greater than would have been achieved if capital was invested elsewhere.

# [edit] Formula

The formula for calculating NPV is as follows:

Where:

- Ct = net cash inflow during the period ‘t’
- Co = total initial investment costs
- r = discount rate
- t = number of time periods

# [edit] Example

A construction project has initial costs of £1.7m. It is expected to generate the following cash inflow:

- End of year 1 = £120,000.
- End of year 2 = £250,000.
- End of year 3 = £550,000.
- End of year 4 = £1.3m.

Without applying discounts for depreciation, the NPV of the project is:

NPV = Benefits – Costs

NPV = £2.22m – £1.7m

NPV = £520,000

Without discounting there is sufficient economic justification for the project to go ahead.

Discounting is a way of comparing the value of costs and benefits over different time periods relative to their present values. Money is worth less in the future than it is in the present because of its reduced capacity for generating a return, such as interest, and because of inflation. Discounting is a means of assessing how much less an amount is worth in the future than it is now.

As property development and construction generally face significant costs over long periods of time, they are particularly susceptible to discount rate sensitivity.

With a 5% discount rate applied to the example project, the NPV becomes:

(Y1) £114,285.70 + (Y2) £226,757.37 + (Y3) £475,110.68 + (Y4) £1,069,513.22

NPV = £1,885,666.97

NPV = 1,885,666.97 – £1.7m

NPV = £185,666.97

So there is still economic justification for the project to go ahead. However, if the discount rate is increased to 10% the NPV is:

(Y1) £109,090.91 + (Y2) £206,611.57 + (Y3) £413,223.14 + (Y4) £887,917.49

NPV = £1,616,843.11

NPV = £1,616,843.11 – £1.7m

NPV = -£83,156.89

In this scenario there appears not to be economic justification for the project to go ahead.

Understanding NPV can help assess whether to proceed with a project, how profitability compares with alternative investments, or may help negotiate down prices.

# [edit] Drawbacks of using NPV

As an analysis tool, NPV has a number of drawbacks:

- Estimated cash flows seldom match those experienced in practice.
- Given the incremental cost of capital required to fund a project, a simple discount rate may not adequately represent the situation.
- Adjustments to take account of risks will only be very rough estimate estimates.
- NPV analysis only considers the circumstances of a specific investment.

# [edit] Find out more

Related articles on Designing Buildings Wiki

- Budget.
- Business plan.
- Capex.
- Capital allowances.
- Capital costs for construction projects.
- Cash flow.
- Development appraisal.
- Discounting.
- Discounted cash flow.
- Discounting.
- Internal rate of return for property development.
- Life cycle assessment.
- Life Cycle Costing BG67 2016.
- Whole life costs.

External references

Investopedia – Net Present Value (NPV)

### Featured articles and news

The origins, evolution and future of Level 3 BIM.

Urban design course essentials

For new and returning Urban Design students, check out our article list divided up into the modules you'll be studying.

Report states that health of urban dwellers could be significantly improved by rethinking transport design.

The Kremlin, the centre of Russian power, includes some of the country's finest architecture.

Report launched outlining steps for a national infrastructure system that is efficient, sustainable, and delivers until 2050.

An Introduction to Passive House

A review of Justin Bere's concise and well-presented introductory guide to Passive House.

This article describes in detail the tender process for a typical commercial construction contract.

What is energy storage, what are the different types and what is its future?

MAD Architects reveal their designs for a state-of-the-art concert hall in Beijing.

Take a look at BIG's designs for two twisting towers in New York City.

'The filing cabinet' which was labelled one of the best British buildings of the 21st century.

Click here to see more featured articles and news.