Net Present Value (NPV) refers to the sum of all the present values of the future net cash inflows from a project subtract the initial cost of the investment. The present value of the cash flows is also known as the discounted cash flow because it is calculated by discounting the cash flow using a discounting factor. The discounting factor is calculated using a discounting rate that is predetermined based on the riskiness of the project in question. Net present value is used to compare to the value of future return of a project to the present value of the same returns. In order to calculate the NPV of a project, the following formula below should be used.
NPV= R1 (1 + i)1 + R2 (1 + i)2 + Rn (1+i)n
Where; i represent the Rate of Return (Discounting Rate)
NPV is used in decision making when considering whether to accept or reject the implementation of a project. After calculating the NPV, The project should be accepted if the NPV is greater than Zero (NPV>0). This is because the project will add value to the operations of the firm. If the NPV is less than zero (NPV<0), the project should be rejected because it will have a negative impact on the firm’s value. When the NPV is equal to 0, the company will be indifferent about whether it should reject or accept the project because it neither brings profit or loss to the company.
Sensitivity analysis, on the other hand, is a technique used to determine the impact of a change in the independent variable on the dependent variable. It helps in predicting the decision’s outcome subject to a variance in the predetermined situation. In this assignment, the discount rate is the independent variable will change to affect the NPV.
Decision after NPV Calculation
Given a 5 year project life, the net present value of the project based on a 10% discount rate is $-1,956.89. The Sum of the present value of expected cash flow amounts to $2,043.11 which after subtracting the initial cost of investment of $4000 gives $-1,956.89. The NPV is less than Zer0 (-1,956.89<0). This implies that the management of the firm should reject the project. This is because implementing the project will lead to a loss to the firm amounting to $-1,956.89. The project will have no additional gain to the value of the firm.
Decision after Sensitivity Analysis
The sensitivity analysis is based on increasing the value of discount rate (independent variable) from 10% to 15%. With a discounting rate of 10%, NPV is $-1,956.89 whereas with a discounting rate of 15%, NPV is -2209.49. With a higher discount rate of 15%, the NPV<0 which means that the firm should also reject the project. This is because the cost still outweighs the discounted cash flows. Even after reducing the discount rate to 5%, the NPV is -$1,643.70 (NPV<0) and thus the optimal would be to reject the project.
In conclusion, NPV is considered as being one of the most reliable and efficient measure during capital budgeting by a company. This is because it puts in consideration the time value of money. Pursuing the decision of rejecting a project whose NPV is Negative is an optimal decision whereas accepting a project with a positive NPV is an optimal decision. Firms should learn to adopt this decision making technique and apply sensitivity analysis when making investment decisions.
Jan, Irfanullah. Net Present Value (NPV). 2012. 27 November 2013. <http://accountingexplained.com/managerial/capital-budgeting/npv>.