Net Present Value or NPV is a classic economic method of evaluation of investment proposals. It is a Discounted Cash Flow (DCF) technique that considers the time value of money. NPV correctly postulates the cash flows that arise at different time periods that are comparable in terms of their present values.
There are some steps that must be followed to calculate NPV. Here are the four rules that must be followed to calculate NPV correctly.
Forecasting Cash Flows − This is the first step of the NPV calculation where an accurate forecast should be made about cash flows of investment projects based on realistic assumptions. Forecasting is important to realize the present value of a future cash flow because it gives the value of an investment according to the time value of money.
Finding an appropriate discount rate − After forecasting the cash flows, an appropriate discount rate should be found for the forecasted cash flows. The appropriate discount rate is the opportunity cost of the project that is equal to the anticipated required rate of return of the investment proposals of equivalent risk.
Calculation of present value of cash flows − After finding the appropriate discount rate, the present value of cash flows must be calculated using the opportunity cost of capital as the discount rate. The opportunity cost of capital is the amount of capital foregone which is related to the second most appealing investment project.
Subtract Cash Outflows from Cash Inflows − The Net Present Value should be calculated by subtracting the value of cash outflows from the value of cash inflows. The value of cash outflows and inflows are found in the previous steps. The net present value calculated can either be positive or negative. The investment projects that have a positive NPV should be undertaken by a firm while the investment projects with a negative NPV should be rejected.
Cash flows in the calculation of NPV are discounted for two basic reasons −
To consider and adjust the risk of an investment opportunity.
To consider the time value of money.
The first reason is important because different instruments, services, and investments have different risks, and considering them as equal can be erroneous while calculating the NPV. For example, risks in investing in government bonds are much lower than investing in a young technology firm. The discount rate is higher for a riskier investment and lower for a less risky one.
The second reason is required because various economic and political reasons may impact the cash flows. These reasons include inflation, interest rates, and opportunity costs to name a few.