Capital budgeting is the process in which a business determines and evaluates possible expenses and investments. In an ideal situation a business would pursue all investments that enhance shareholder value however in the real world where capital is limited, capital budgeting is used to determine which projects will bring the most return to the business over a period of time. Net present value (NPV), a part of capital budgeting, is used to analyse the profitability of a project’s investment. By determining the NPV of possible investments a business can identify which investments will produce the greatest benefits for the business.
The NPV represents the difference between the present value of cash inflows and the cash outflows. A positive net present value indicates that the projected earnings of an investment exceed the anticipated costs.
During a company’s decision making process or when comparing projects, the NVP becomes the tool of choice for many. This is because the NPV accounts for time value of money. This simply means that future money has less value than money at the present due to the inflation rate. This is accounted for by incorporating a discount rate when calculating the NPV. By doing so, the value produced allows managers to easily compare any initial outflows against the present value of returns expected.
However, when this method of capital budgeting done is used there is concern about reliability. NPV analysis is sensitive to the reliability of the predicted cash inflow for an investment or project and as a result is, not always accurate.
An initial investment of $250 on a crop monitoring sensor is expected to generate inflows of $500 each year for the next 5 years. A second investment option of a similar system involves an initial investment of $500 and is expected to produce inflows of $650 yearly. Using a discount rate of 8%, the NPV of the investments can be found to help determine the best investment.
The cash flows shown below represent the two investment options.
|Discount Factor: 10%|
C = Cash Flow
i = interest rate/discount rate
N = number of periods
Present Value of Project A Costs
Year 0 : 250
Year 1: 46.29
Year 2: 42.87
Year 3: 39.69
Year 4: 36.75
Year 5: 34.03
Present value of total cost = $449.63
Present Value of Project A Benefits
Year 1: 462.90
Year 2: 428.70
Year 3: 396.90
Year 4: 367.50
Year 5: 340.30
Present Value of total benefits = 1996.3
NPV = 1996.3 – 449.63 = 1546.67
Present Value of Project B Costs
Year 0: 500
Year 1: 69.44
Year 2: 64.30
Year 3: 59.53
Year 4: 55.13
Year 5: 51.04
Present value of total cost = 799.45
Present Value of Project B Benefits
Year 1: 601.85
Year 2: 557.27
Year 3: 515.99
Year 4: 477.77
Year 5: 442.38
Present Value of total benefits = 2595.25
NPV = 2595.25 – 799.45 = 1795.8
Based on the net present value decision rule, both of the investments are worthwhile. However, project B provides greater benefits over the 5 year period and therefore should be prioritised over project A.