# 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.

NRM3: Order of cost estimating and cost planning for building maintenance works, suggests that:

NPV is a standard measure in LCC (life cycle cost) analyses, used to determine and compare the cost effectiveness of proposed solutions. It can be applied across the full range of construction investments, covering whole investment programmes, assets, systems, components and operating and maintenance models.The costs and revenues/benefits to be included in each analysis are defined according to its objectives. For example, revenues from recycling of materials or from surplus energy generation are typically included in LCC analysis of alternative sustainability options. |

# [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 = £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

### [edit] Related articles on Designing Buildings Wiki

- Base year.
- Budget.
- Business plan.
- Capex.
- Capital allowances.
- Capital costs for construction projects.
- Cash flow.
- Compound Annual Growth Rate (CAGR).
- Cost performance index (CPI).
- Cost-benefit analysis in construction.
- Development appraisal.
- Discounting.
- Discounted cash flow.
- Discounting.
- Gross value added (GVA).
- Internal rate of return for property development.
- Investment.
- Life cycle assessment.
- Life Cycle Costing BG67 2016.
- Profitability.
- Solvency.
- Whole life costs.
- Yield.

### [edit] External references

- Investopedia – Net Present Value (NPV)
- CBA Builder

### Featured articles and news

Infrastructure interconnectivity

ICE publish a policy paper on the UK’s future interconnectivity with the EU and the challenges for infrastructure.

Detailed guidance about construction waste management.

The changing identity of London communities in the face of rapid urbanisation.

Can you help? We have 300 industry acronyms beginning with 'C' but none beginning with 'Y'.

From the sinister Carceri d’Invenzione to the triple portrait of Sir Watkin Williams-Wynn and his Grand Tour travelling companions.

Design freeze: a quality perspective

Progressively freezing a design helps ensure it meets the specification when built.

BSRIA launch the 5th edition of the Design Framework for Building Services (BG 6/2018).

Stella Rimmington famously said the construction industry was just as tricky as the KGB.

CSCS

Construction site visitor cards are to be withdrawn.

3 WTC opens, RSHP’s first built project in New York.

We have a lots of articles about lifts - this introduction is a good place to start.

BREEAM ES and SIMA present for the first time a reproduction of a sustainable home.