NPV – Net Present Value is a simple concept used by accountants the world over to calculate if an investment is worth making or not. Most businesses do not have infinite access to capital and decisions need to be made in terms of which investments should be made and which should not proceed, at least for the time being. While there will always be some investment decisions, e.g. addressing health and safety issues or risks, which may not be simple to factor into an NPV calculation, many investments can be ranked using NPV.
Whilst Microsoft’s definition of the NPV function, “calculates the net present value of an investment by using a discount rate and a series of future payments (negative values) and income (positive values)” can feel intimidating what the calculation is fairly straight forward. “Will this investment create an increase in value, taking into account the organisation’s cost of capital and if so how much value will it create?”
There are only a few inputs to the formula:
The cost of capital – This is the rate of return that the investors expect on the investment or the cost of borrowing the money. The higher the risks in the industry the higher the expected return on any investment made in that industry and the higher the cost of the capital for investments made within that industry. Vector (a lines company) had a 2019 cost of capital of circa 4.7%, whereas Serko (a technology company) had a cost of capital of circa 17.9%.
The amount invested each year – how much needs to be invested each year?
The formula in excel is as follows: =NPV(Rate, value 1, value 2, value 3).
However, the trick to getting a good NPV comparison is to understand the net position each year, i.e. income minus expenditure, and to calculate the NPV value on this net figure.
A worked example is as follows:
ABC scooters and bikes has $15,000 available to invest over the next 3 years and is reviewing 2 proposals – one from the Scooter production unit and one from the E-Bike production unit.
The scooter production unit requires no upfront costs but will need $5,000 a year over the next 3 years. It will generate $10,000 of revenue in year 1, $8,000 in year 2 and $8,000 in year 3.
The E-Bike production unit requires no upfront costs but will also need $5,000 over the next 3 years. It will generate $10,000 of revenue in year 1, $6,000 in year 3 and $10,000 in year 3.
Which is the best investment?
The best investment is the investment with the highest NPV, which is Scooter Production. This investment would produce an NPV of $9,279, compared to $9,128 for E-Bike Production. Effectively the NPV is the net positive investment after the anticipated margin has been discounted for the cost of the capital.
To bring the margin values back to present value the NPV calculation discounts year 1 by 10%, year 2 by 10% (squared) and year 3 by 10% to the power of 3. The math does not need to be understood to apply the NPV calculation but I always find that it is useful to understand the basis for the calculation and the logic, wherever possible.
Note that both investments generate a margin of $11,000 over 3 years, but because the E-Bike investment produces less revenue in year 2, and then higher revenue in year 3, and because year 3 is discounted by 10% to the power of 3 to bring it back to present dollars, the overall NPV for E-Bikes is lower than the NPV for Scooters (not by much though).
In conclusion, if ABC scooters and bikes had limited funds to invest over the next 3 years, they would select the scooter investment because it will give them a slightly higher return than the E-Bike investment.