Net Present Value (NPV) - Capital Budgeting

The essence of corporate financial management (and your job as a financial manager) is to create value for the shareholders. Value? By value we mean an investment that has more value than what it costs to purchase or build. Take this example. Say we buy a broken down house for $100,000. We spend $35,000 for major repairs and upgrades. The total cost adds up to $135,000 right? Now what if the value of the house in the market was $160,000? This means we've created a value of $160,000 - $135,000 = $25000

The challenge of financial management comes when you have to determine beforehand that the $35000 repairs and upgrades you've done on the property will actually net you a positive return. How do you distinguish from good and bad investments? This is called capital budgeting and the difference between an investment's cost and its value is called the Net Present Value (NPV).

How do you Calculate Net Present Value (NPV)?

You calculate NPV by combining the initial investment with the annual cash flows and the expected # of years the cash flows are expected to be produced for. An example would best prove this:

Q: XYZ Corporation has $25000 to invest. The following alternative investments and their annual cash flows are presented. The company's required rate of return is 8.3% interest compounded monthly. Which investment would you (as a financial manager) pick? Why?

Notes:

CFO = Initial Investment and is always entered as a negative (since the company is paying out the money). E.g an initial investment of $-10,000 means the company paid out that amount.

CO1 = Cash flow (in) for Year 1
CO2 = Cash flow (in) for Year 2
CO3 = Cash flow (in) for Year 3... etc

	A	B	C	D	E	F
CFO	-10000	-10000	-10000	-25000	-25000	-15000
CO1	800	-50	4000	8000	-500	4000
CO2	800	100	1000	8000	15000	4000
CO3	700	400	500	8000	15000	3000
CO4	700	400	500	1000	10000	3000
CO5	400	700	500	-500		2000
CO6	400	900	3000	-500
CO7	300	900	3000
CO8	200	4000
CO9	100
CO10	-50

In order to perform this calculation, we are going to use the BAII Plus Financial Calculator.

Investment A

In your calculator, type in 2nd -> CF

CFO = -10,000
CO1 = 800
FO1 = 1 (means cash flow for 1 year)
CO2 = 800
FO2 = 1
CO3 = 700
FO3 = 1
CO4 = 700
FO4 = 1
CO5 = 400
FO5 = 1
CO6 = 400
FO6 = 1
CO7 = 300
FO7 = 1
CO8 = 200
FO8 = 1
CO9 = 100
FO9 = 1
CO10 = -50
FO10 = 1

CPT -> NPV

I = 8.3% (this is the company's required rate of return)

NPV -> CPT = -$6699.30

Investment B

In your calculator, type in 2nd -> CF

CFO = -10,000
CO1 = -50
FO1 = 1 (means cash flow for 1 year)
CO2 = 100
FO2 = 1
CO3 = 400
FO3 = 1
CO4 = 400
FO4 = 1
CO5 = 700
FO5 = 1
CO6 = 900
FO6 = 1
CO7 = 900
FO7 = 1
CO8 = 4000
FO8 = 1

CPT -> NPV

I = 8.3% (this is the company's required rate of return)

NPV -> CPT = -$5698.90

Can you follow these steps to discount the cash flows for each of the Investments from C to F? If you do, you should get the following answers:

	A	B	C	D	E	F
Initial Investment	10000	10000	10000	25000	25000	15000
NPV	$-6699	-$5699	-$785	-$4413	+$6405	-$2011

The rules of NPV?

- If an investment has a Positive NPV, then go ahead and do it!
- If an investment has a Negative NPV, then do not invest in it!

From the above investments ranging from A to F, which one would you go ahead and invest in?

Solution: Considering the rules of NPV, pick investment E because it is the only one that has a POSITIVE Net Present Value (NPV) of $6405. The rest all bring in NEGATIVE NPVs.