Page 178 - DMGT521_PROJECT_MANAGEMENT
P. 178
Unit 10: Measuring Project Profitability
In the case when all future cash flows are incoming (such as coupons and principal of a bond) and Notes
the only outflow of cash is the purchase price, the NPV is simply the PV of future cash flows
minus the purchase price (which is its own PV). NPV is a central tool in discounted cash flow
(DCF) analysis and is a standard method for using the time value of money to appraise long-
term projects. Used for capital budgeting and widely used throughout economics, finance, and
accounting, it measures the excess or shortfall of cash flows, in present value terms, once financing
charges are met.
NPV can be described as the “difference amount” between the sums of discounted: cash inflows
and cash outflows. It compares the present value of money today to the present value of money
in future, taking inflation and returns into account.
The NPV of a sequence of cash flows takes as input the cash flows and a discount rate or discount
curve and outputs a price; the converse process in DCF analysis — taking a sequence of cash
flows and a price as input and inferring as output a discount rate (the discount rate which would
yield the given price as NPV) — is called the yield and is more widely used in bond trading.
Formula: Each cash inflow/outflow is discounted back to its Present Value (PV). Then they are
summed. Therefore NPV is the sum of all terms,
R t
(1 i ) t
where
t - the time of the cash flow
i - the discount rate (the rate of return that could be earned on an investment in the financial
markets with similar risk); the opportunity cost of capital.
- the net cash flow (the amount of cash, inflow minus outflow) at time t. For educational purposes,
is commonly placed to the left of the sum to emphasize its role as (minus) the investment.
The result of this formula is multiplied with the Annual Net cash inflows and reduced by Initial
Cash outlay the present value but in cases where the cash flows are not equal in amount, then the
previous formula will be used to determine the present value of each cash flow separately. Any
cash flow within 12 months will not be discounted for NPV purpose.
!
Caution The NPV of a sequence of cash flows takes as input the cash flows and a discount
rate or discount curve and outputs a price.
10.3.1 The Discount Rate
The rate used to discount future cash flows to the present value is a key variable of this process.
A firm’s weighted average cost of capital (after tax) is often used, but many people believe that
it is appropriate to use higher discount rates to adjust for risk or other factors. A variable
discount rate with higher rates applied to cash flows occurring further along the time span
might be used to reflect the yield curve premium for long-term debt.
Another approach to choosing the discount rate factor is to decide the rate which the capital
needed for the project could return if invested in an alternative venture. If, for example, the
capital required for Project A can earn 5% elsewhere, use this discount rate in the NPV calculation
to allow a direct comparison to be made between Project A and the alternative. Related to this
concept is to use the firm’s reinvestment rate. Reinvestment rate can be defined as the rate of
LOVELY PROFESSIONAL UNIVERSITY 173
