What is Net Present Value?

Any capital investment involves an initial cash outflow to pay for it, followed by cash inflows
in the form of revenue, or a decline in existing cash flows that are caused by expense
reductions. We can lay out this information in a spreadsheet to show all expected cash flows
over the useful life of an investment, and then apply a discount rate that reduces the cash flows
to what they would be worth at the present date. This calculation is known as net present value
analysis.

Net present value is the traditional approach to evaluating capital proposals, since it is based on
a single factor cash flows that can be used to judge any proposal arriving from anywhere in
a company.

Net Present Value Example

ABC International is planning to acquire an asset that it expects will yield positive cash flows
for the next five years. Its cost of capital is 10%, which it uses as the discount rate to construct
the net present value of the project. The following table shows the calculation:
Year Cash Flow Discount Factor* Present Value

0 -$120,000 1.000 -$120,000

1 +35,000 .9259 +32,407

2 +35,000 .8573 +30,006

3 +35,000 .7938 +27,783

4 +25,000 .7350 +18,375

5 +25,000 .6806 +17,015

 Net Present Value = +$5,586

The reason why the discount rate has a greater impact on cash flows further away in time is that
these cash flows are worth less, since you have to wait longer to receive them.

The Net Present Value Formula

The discount rate is included in present value tables that are readily available in books on
accounting and finance. Discount rates can also be calculated using the following formula:

Present value of Future cash flow

a future cash flow = -----------------------------------------------------------------------------------
(1 + Discount rate) (Squared by the number of periods of discounting)

Using the preceding formula, if there is an expectation of receiving $150,000 in one year, and
the current discount rate is assumed to be 10%, then the calculated net present value of the
future cash receipt is:

$150,000
Present value = ------------------
(1 + .10)1

Present value = $136,363.64

Additional Net Present Value Factors

There can be a considerable number of variations on the possible cash flows associated with a
business decision, making the net present value calculation more difficult to derive. The
following factors may also need to be considered:

Throughput on goods sold. If the decision relates to an investment that will result in the sale of
goods, include cash flows from the throughput generated by these goods. Throughput is sales
minus all totally variable expenses.
 Cash from sale of asset. If an asset is to be purchased, also assume that some cash will be
received at a later date from the eventual sale of that asset.
Maintenance costs. If there will be incremental costs incurred to maintain a purchased asset,
include the cash flows associated with these costs. Do not include any cash flows related to
maintenance personnel who will still be paid, irrespective of the presence of the asset.
Working capital. If there will be an incremental change in the amount invested in accounts
receivable or inventory as the result of a purchase decision, include these cash flows in the
analysis. If the asset is to be eventually sold off, this may mean that the related working capital
investment will be terminated at the same time.
Tax payments. Include any property taxes related to assets that are acquired. Also, include the
amount of any incremental income taxes paid, if the acquired asset generates profits.
Depreciation effect. Include the effect on income taxes paid of the depreciation expense
associated with an acquired asset. This effect is caused by the tax deductibility of depreciation.

In short, net present value analysis is an effective way to aggregate the cash flows associated
with a business decision that are spread over a number of time periods, though some analysis
may be required to accumulate all of the relevant cash flows.

Expected value is defined as the difference between expected profits and expected costs. Expected profit is the
probability of receiving a certain profit times the profit, and expected cost is the probability that a certain cost
will be incurred times the cost.
Example 6-2:
A wheel of fortune in a gambling casino has 54 different slots in which the wheel pointer can stop.
Four of the 54 slots contain the number 9. For a 1 dollar bet on hitting a 9, if he or she succeeds, the
gambler wins 10 dollars plus return of the 1 dollar bet. What is the expected value of this gambling
game? What is the meaning of the expected value result?

Probability of Success = 4/54

Probability of Failure = 50/54
Expected Value = Expected Profit - Expected Cost = (4/54)*10-(50/54)*1= - $0.185

- 0.185 dollar indicates that if the gambler plays this game over and over again, the average gain for
the gambler per bet equals - 0.185 dollar, which means the gambler will lose 0.185 dollar per bet.
Note that for a satisfactory investment, positive expected value is a necessary, but not sufficient,
condition.