Net Present Value (NPV)

Quick reference

• 00:03 Hi, this is Ray Sheen.
• 00:05 Let's look at the ROI technique known as net present value.
• 00:08 This is the most popular technique for calculating ROI on large projects.
• 00:15 Net present value is focused on the growth and business value over some time period.
• 00:20 The net present value, or NPV,
• 00:21 is determined by summing the annual period totals of project cash flows,
• 00:26 both the cost and the benefits, over several years, and then discounting them.
• 00:30 It's similar to the cumulative cash flow calculation that we
• 00:33 have on the spreadsheet.
• 00:34 But by adding the discounting affect,
• 00:36 we have a better sense of the true value created.
• 00:39 If the NPV is negative, don't do the project,
• 00:41 because it drains value from the business.
• 00:43 If the NPV is positive, do the project, because it adds value.
• 00:47 If comparing between projects, do the project with the highest NPV,
• 00:50 it will add the most value.
• 00:52 Unlike payback period and break even point, NPV looks to long term benefits.
• 00:57 It includes what happens after the point where cost and benefits are equal,
• 01:01 to determine what is happening to the business value over the long term.
• 01:05 I mentioned in a previous module that different ROI techniques could prioritize
• 01:09 projects differently.
• 01:10 A project may have a very fast payback period, but
• 01:13 provide very little long term benefit.
• 01:15 Another project may have a slower payback period, but
• 01:18 the long term benefit could keep growing exponentially.
• 01:22 NPV will highlight this long-term business value growth.
• 01:25 It is not about time, it's about money.
• 01:29 I mentioned that NPV discounts the annual period totals.
• 01:32 Let's talk about that for a minute.
• 01:34 Discounted cash flow considers the opportunity costs of the money invested in
• 01:37 the project.
• 01:38 The opportunity cost is the income or savings that the money you invested in
• 01:42 the project could have earned, and the best alternative that could be considered.
• 01:46 Discounted cash flows will convert the money in future years
• 01:50 into what the money is worth today.
• 01:52 It recognizes that there may be inflation or deflation effects.
• 01:55 It considers how the money could have been invested in other financial instruments,
• 01:59 and what interest or dividend rate would be available for that investment.
• 02:02 And it considers the interest rate that is being charged to borrow money.
• 02:06 All of these are combined to create a discount rate,
• 02:09 sometimes called a hurdle rate.
• 02:10 The discount rate for every company is different based upon the company's
• 02:14 financial situation and the industry conditions.
• 02:16 Your finance department will set a rate each year and sometimes twice a year.
• 02:21 And that is what you should use for discounting.
• 02:23 Discounted cash flow is used for projects with long term cost and benefits.
• 02:27 My rule of thumb is, that if I'm using more than two years of my
• 02:30 ROI calculations, I use an ROI technique that uses discounted cash flow.
• 02:35 Less than two years, and the discounting effect is so
• 02:38 small, it usually does not significantly impact the ROI results.
• 02:42 The two ROI techniques that use discounted cash flow are net present value and
• 02:47 the internal rate of return.
• 02:49 So let's look at the NPV calculation.
• 02:52 It starts with the ROI spreadsheet in the annual totals.
• 02:55 Be sure that each column represents a year.
• 02:57 Many companies will actually list the calendar or
• 02:59 fiscal year at the top of the column.
• 03:02 When this is the case, the first column will not have a full year's worth of
• 03:05 project costs, unless the project starts on the first day of the year.
• 03:09 That's okay for this analysis.
• 03:11 The NPV calculation is not jeopardized by a partial year in the first column.
• 03:15 The spreadsheet should sum every column for you.
• 03:18 The NPV will use this period total, not the cumulative total.
• 03:22 Using the cumulative is a common mistake that will likely inflate your NPV
• 03:26 to unrealistic levels.
• 03:28 This is the formula.
• 03:29 NPV is the sum of each of the year's period totals
• 03:32 after they have been discounted using the discount rate.
• 03:35 Note that the NPV calculation is for some set period of years.
• 03:39 Again, finance will normally dictate how many years to use
• 03:42 based upon the project time.
• 03:44 However many years you are directed to use,
• 03:46 that is the number of columns you will need in the spreadsheet.
• 03:50 NPV calculations are not normally done by hand.
• 03:52 The spreadsheet will do them for you.
• 03:55 One caution when using the NPV function in Excel,
• 03:58 it starts discounting with the first column that is in the function.
• 04:02 Now, if you are doing an NPV calculation for a business case or
• 04:05 a project that will start next year, that's okay.
• 04:07 But if you're doing an NPV calculation for a project that's about to start in
• 04:11 this year, the first year's money should not be discounted.
• 04:15 Discounting always starts with next year's money.
• 04:18 So in that case, remove the current column from the Excel NPV formula, and
• 04:22 add that to year's total to the discounted total from the NPV function.
• 04:26 The Excel equation for this case is shown.
• 04:30 Let's look at an example.
• 04:31 Here are the spreadsheet totals for a ten month IT project that costs $450,000 and
• 04:36 introduces a new sales order management system.
• 04:39 During year one, the operations suffer from loss of productivity
• 04:43 as they come up to speed on the new system.
• 04:45 After that, they get continued productivity improvement each year, and
• 04:48 with the new system, they're even able to reach some new customers.
• 04:51 You can see the period totals for each year.
• 04:54 If we just added the values for each year out through year six,
• 04:57 we would have a cumulative value of $1,650,000.
• 05:01 But because this is a project with a long-term impact,
• 05:04 we use discounted cash flow.
• 05:06 For this example, finance gave us a discount rate of 15%.
• 05:09 We plug the numbers in to the equation, and get a net present value of $893,674,
• 05:15 just barely over half of what the cumulative value would have been, but
• 05:20 a better indication of the value of the project, which is still very good.
• 05:24 For project investment of 450,000, the business not only earns back
• 05:28 the investment, it makes another $893,000 within six years.
• 05:32 Net present value is an excellent technique for
• 05:36 determining the long-term value of a project.
• 05:39 If you've completed the ROI spreadsheet, it's an easy calculation.

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