Net present value is generally known as NPV. It is an investment criterion to evaluate any project. Chief financial officers generally used NPV as investment criteria in the investment decision known as capital budgeting and it is the pivotal to the success of the firm. Capital investments for a while needs significant total of cash and also have long-term consequences. A firm’s stakeholders want to be healthier rather than poor. Therefore, shareholders prefer to invest in projects which worth more than the cost.
The main difference between projects’ cost and its value is known as net present value. Firms can help their stakeholders by investing in projects with a positive NPV. Firms’ sometime compare the expected rate of return (IRR) from investing in a business with the expected return the shareholders can receive on equivalent risk projects in the capital market. Firms only accept those projects that have greater return than the return of shareholders’ personal businesses.
Taking the example of real estate business; a firm wants to purchase land of $100,000 and construction cost for a building further requires $500,000. The firm expects that after one year building would be sold for $700,000. Thus the firm would be investing $600,000 today in the expectation of earning $700,000 after one year. Now the firm would only go for the project, if the PV of the $700,000 payoff is higher than the investment of $600,000. Think for the time that the $700,000 payoff is a definite obsession. A firm has also other alternatives for investment; for example it can invest in one year Treasury notes. Assume that treasury notes gives an interest rate of 8 %, how much would a firm has to invest today in treasury notes to realize $700,000 after one year.
700,000*1/1.08=700,000*0.926 = 648,200
PV of the 700,000 payoff from the home selling is 648, 200. Let’s suppose that the firm has purchased the land and constructed the house, now it has decided to cash in on its project, how much could the firm sell it for. Home will be worth of 700,000 after a year. Today investors want to pay at most 648,200. It would also cost the firm to get same amount of 700000 by investing in securities.
The PV of 648200 is the only amount that satisfies both seller and buyer. PV of anything is its market value and it is the only feasible value. PV is calculated by discounting the future payments at the ROR given by different investment alternatives. Discount rate used in the above example is generally known as opportunity cost of capital because it is given up by investing in the real estate project.
The house is worth 648,200; the firm has invested 600000 so its NPV is 48200. NPV is calculated by subtracting initial investment (II) FROM PV of the cash flows:
NPV = PV – II
648,200-600,000 = 48,200