Management’s main job is to create value for shareholders. How do they know if a new project will create or destroy value for the firm? Net present value serves as a guide for these decisions.
What Is Net Present Value?
Markets always discount future expectations to the current environment. This is seen through opportunity costs and expected cash flow. Net present value (NPV) compares the current cash outflow against the present value of expected future cash flow. Found below is the equation for net present value:
Ct = net cash flow during time t
Co = total cost of investment
r = discount rate
t = time periods
Additionally, management considers any positive expected NPV worth profitable. Conversely, a negative NPV results in a loss. The time value of money theory lies at the root of this equation. This assumes that a dollar made in the future is worth less than a dollar made today. Dollar made today immediately contribute to future growth.
Net Present Value In Depth
Management uses this calculation in making purchases of financing decisions. Evaluating the discount rate is different in many cases. However, the same base premises remain. Companies compare estimated returns of projects with similar risk, or compare the discount rate to the current cost of borrowing money.
For example, companies that require heavy machinery face this dilemma frequently. If new equipment costs $200,000 up front, and management estimates the discounted future cash flow of the useful life of that equipment over $200,000, management considers this a positive NPV endeavor and pursues it.
One way management evaluates discount rates is the internal rate of return (IRR). IRR is the discount rate rate of an investment when the NPV is 0. This tells management the anticipated growth rate of an investment. This is one way management finds an accurate discount rate against which to evaluate the NPV of projects.
Net present value is invaluable to both management and shareholders. If shareholders believe management pursues negative NPV projects, they either voice their opinion, or sell shares of stock thinking the company will be less valuable. Management’s goal is to create value with positive NPV investments.