Last edited 07 Apr 2017

Net Present Value

1 Introduction
2 Formula
3 Example
4 Drawbacks of using NPV
5 Find out more
- 5.1 Related articles on Designing Buildings Wiki
- 5.2 External references

[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.