Investment Appraisal Worked Example: Net Present Value (NPV)

Investment appraisal is crucial for making informed decisions about capital projects. One of the most widely used methods is Net Present Value (NPV). This example demonstrates how to calculate and interpret NPV.

Scenario

A company is considering investing in new machinery that costs $200,000. This investment is expected to generate the following cash flows over the next four years:

Year 1: $70,000
Year 2: $80,000
Year 3: $90,000
Year 4: $60,000

The company’s required rate of return (discount rate) is 10%.

Steps to Calculate NPV

1. Determine the Discount Factor for Each Year

The discount factor is calculated using the formula: 1 / (1 + r)^n, where ‘r’ is the discount rate and ‘n’ is the year.

Year 1: 1 / (1 + 0.10)^1 = 0.9091
Year 2: 1 / (1 + 0.10)^2 = 0.8264
Year 3: 1 / (1 + 0.10)^3 = 0.7513
Year 4: 1 / (1 + 0.10)^4 = 0.6830

2. Calculate the Present Value (PV) of Each Year’s Cash Flow

Multiply each year’s cash flow by its corresponding discount factor.

Year 1: $70,000 * 0.9091 = $63,637
Year 2: $80,000 * 0.8264 = $66,112
Year 3: $90,000 * 0.7513 = $67,617
Year 4: $60,000 * 0.6830 = $40,980

3. Sum the Present Values of All Cash Flows

Add up the present values calculated in the previous step: $63,637 + $66,112 + $67,617 + $40,980 = $238,346

4. Subtract the Initial Investment

Subtract the initial investment from the sum of the present values: $238,346 – $200,000 = $38,346

Result

The Net Present Value (NPV) of this investment is $38,346.

Interpretation

A positive NPV indicates that the investment is expected to generate more value than its cost, considering the time value of money. In this case, the positive NPV of $38,346 suggests that the company should accept the investment project. It is expected to increase the company’s wealth. A negative NPV would suggest rejecting the project.

Conclusion

NPV is a powerful tool for investment appraisal. It considers the time value of money and provides a clear indication of whether an investment is likely to be profitable. This example illustrates the step-by-step process of calculating NPV and interpreting the result to make sound investment decisions.