ROI Guide: Net Present Value

Definition: The net present value (NPV) of an investment is the present (discounted) value of future cash inflows minus the present value of the investment and any associated future cash outflows.

What it means: It's the net result of a multiyear investment expressed in today's dollars.

Strengths: By considering the time value of money, it allows consideration of such things as cost of capital, interest rates and investment opportunity costs. It's especially appropriate for long-term projects.

Weaknesses: Ranking investments by NPV doesn't compare absolute levels of investment. NPV looks at cash flows, not at profits and losses the way accounting systems do. NPV is highly sensitive to the discount percentage, and that can be tricky to determine.

Unlike the more widely used payback period, NPV accounts for the time value of money by expressing future cash flows in terms of their value today. It recognizes that money has a cost (interest), so that you would prefer to have $1.00 today to having $1.00 a year from now. If you earn 10% interest on your money, $1.00 today will be worth $1.10 a year from now. Or, turning that around, the "present" value of $1.10 one year out is $1.00.

You probably wouldn't want to make an investment that's estimated to produce a negative NPV. The bigger the NPV—other things being equal—the more attractive the investment is.

Computing NPV requires use of a discount rate equal to some minimum desired rate of return. This could be your company's average weighted cost of capital (debt and equity) as computed by your finance department. If capital costs your company 10%, you aren't likely to invest that capital for an 8% return. Unfortunately, computing the cost of capital can be difficult and controversial.

The discount rate (say, 10%) determines the discount factor for each year (say, .909) that is applied to that year's cash flow to convert it to today's dollars. The discount factor for year n can be computed as: discount factor = 1/(1+i)n, where i is the target rate of return. So at a discount rate of 10% in Year 1, discount factor = 1/(1.1), or .909. Thus, in the earlier example, the present value of $1.10 a year from now is $1.10 x .909, or $1.00.

Fortunately, this math is automated in spreadsheet packages. You enter only the undiscounted cash flows, the years in which the flows are expected and some target interest rate. NPV will pop out.

The chart below compares two projects that a bank could undertake. Each has an initial investment of $1 million and a minimum desired rate of return of 10%. On the basis of absolute (undiscounted) return, the ATM installation is better because it generates $250,000 more cash over the life of the investment. But when the time value of money is considered, the server consolidation project looks slightly better, with an NPV higher by $9,000. Its present value is higher because the returns occur earlier in the project's life.

Gaylord Entertainment Co., a Nashville-based hotel and resort company, relies on relatively simple measures such as payback period to evaluate investments of less than $100,000. Between $100,000 and $500,000, it also looks at discounted cash flow (DCF). "And above $500,000, DCF is absolutely necessary," says CIO Kent Fourman.

The yearly cash flows from a hotel or entertainment project are net revenues, but for an IT project, they generally are cost savings, Fourman says. But he says NPV isn't appropriate for an IT project that can't be associated with clearly defined cash flows.

"We are doing Windows 95 to Windows 2000 and XP conversions, for example, and you're not going to come up with a traditional DCF on that kind of project," Fourman says. "There are benefits that are not necessarily financial in nature."

NPV has some flaws, says Ian Campbell, chief research officer at Nucleus Research Inc. in Wellesley, Mass. He offers an example in which two investments each have an NPV of $100, but one involves an initial investment of $1,000 and the other an investment of $1 million. Clearly the $1,000 investment is preferable because it's less risky and ties up less capital, he says.

But, Campbell adds, NPV is a good "no-go indicator," because you'd normally reject an investment with a negative NPV without further consideration. Those with a positive NPV should then be measured by other yardsticks, he says.

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Net Present Value: What It Looks Like

ATM installation

Server consolidation

YearDiscount factor (at 10%)Cash flowPresent value of cash flowCash flowPresent value of cash flow
01.000-$1 million-$1 million-$1 million-$1 million
10.909+$500,000+$454,500+$1 million+$909,000
20.826+$500,000+$413,000+$750,000+$619,500
30.751+$500,000+$375,500+$500,000+$375,500
40.683+$500,000+$341,500
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50.621+$500,000+$310,500
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Total

+$1.5 million

+$895,000

+$1.25 million

+$904,000

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NPV considers the time value of money. In this example, we compare two $1 million projects with a minimum desired rate of return of 10%. On the basis of simple cash flow, the ATM installation looks better because it generates $250,000 more over the life of the investment. But when the time value of money is considered, the server consolidation project looks slightly better, with an NPV higher by $9,000, because the returns occur earlier in the project's life.

Special Report

Do the Math! An ROI Guide

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