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How to calculate NPV in Capital Budgeting?

CAPITAL BUDGETING: It is a decision tool with the help of which organization’s or company’s determine that the decision related to long term investment like purchasing new machinery , new company or new asset and taking new projects etc are worth for company’s investment value or not.

There are 5 technique used in Capital budgeting these are as follow:

v Discounted Cash Flow (NPV)
v  Internal Rate of Return (IRR)
v    Payback period
v  Accounting Rate of Return
v  Profitability Index

Net Present Value (NPV) or Discounted Cash Flow:
It helps to the companies or investors to take decision to accept or reject the investment proposal. With the help of NPV companies or investors will correctly determine the best investment proposal among many alternatives.

If,
NPV > 0 investment proposal accepted,
NPV < 0 Investment proposal rejected and
NPV = 0 Investment proposal accepted

Formula for Net Present Value (NPV):

Formula
Fixed cash flows
Uneven Cash Flows
NPV
-C0+ C*1-(1+r) –n/(1+r) n
-C0+C1/ (1+r) n+C2/ (1+r) n+…….C n/ (1+r) n

Where,
C0= Initial investment
C1, C2….C n = Future cash flows
R = rate of interest

Example: Find out the NPV for a project that cost Rs. 2, 00,000 and it is expected cash flows are as follows: Rs. 20,000, Rs. 27,000,Rs.39,000, Rs.53,000, Rs.64,000 and Rs.76,000 and cost of capital is 9%.

NPV = -C0+C1/ (1+r) n+C2/ (1+r) n+…….C n/ (1+r) n
=-2, 00,000+20,000/ (1+0.09) 1+27,000/ (1+0.09) 2+39,000/ (1+0.09) 3+53,000/ (1+0.09) 4+64,000/ (1+0.09) 5+76,000/ (1+0.09) 6
= -2, 00,000+18,348.62+22,725.35+30,115.15+37,548.70+41,596.25+45,316.31
=-2, 00,000+1, 95,650.38
=-4,349.62
NPV < 0 =-4,349.62 < 0

Therefore, Investment proposal is rejected.

To determine the true value of an investment project you must consider two economic factors inflation and deflation.

NPV adjusting inflation:

There are two methods to calculate NPV in inflation-

·         Nominal Method: Estimating nominal cash flows (it does not include effects of inflation) and then discounting them. In other words this method discount inflated cash flow at inflated rate.

·         Real Method: Estimating real cash flows (it includes effects of inflation) and then discounting them with the real discount rate. In other words this method discount deflated cash flow at deflated discount rate.

Nominal Method:

Nominal Cash Flows=Real cash flow *(1+inflation rate) n
  
Nominal Discount rate=Real discount rate + Inflation rate

Example: Company A has a proposal to invest in some project whose initial investment is Rs.5, 00,000 and expected cash flow is Rs.200000 per year for 4 years. The inflation rate is 4% and nominal discount rate is 7.5%.Find out the NPV of a project.

Calculation of Nominal Cash Flows:

Years
Calculation
Nominal Cash Flow (Rs.)
1
200000*(1+0.04) 1
2,08,000
2
200000*(1+0.04) 2
2,16,320
3
200000*(1+0.04) 3
2,24,972.8
4
200000*(1+0.04) 4
2,33,971.7


Calculation of Net Present Value:

Years
Nominal Rate
7.5%
Nominal cash flow
Rs.
Present Value
Rs.
0


(7,00,000)
1
(1+0.075) 1=1.075
2,08,000
1,93,488.37
2
(1+0.075) 2=1.156
2,16,320
1,87,128.02
3
(1+0.075) 3=1.242
2,24,972.8
1,81,137.52
4
(1+0.075) 4=1.335
2,33,971.7
1,75,259.70
Total


7,37,013.61
NPV


37,013.61

Real Method:
Real cash flow = Nominal cash flow/ (1+inflation rate) n 

Real Discount Rate = (1+Nominal Discount Rate)/ (1+Inflation Rate)-1
OR
 Nominal Discount Rate-Inflation Rate

Let’s take above example to find NPV according to Real Method

Calculation of Net Present Value:

Years
*Real Discount Rate
3.3%
Real Cash Flow
Present Value
0


(7,00,000)
1
(1+0.033) 1=1.033
2,00,000
1,93,610.84
2
(1+0.033) 2=1.067
2,00,000
1,87,441.42
3
(1+0.033) 3=1.102
2,00,000
1,81,488.20
4
(1+0.033) 4=1.138
2,00,000
1,75,746.92
Total


7,38,287.38
NPV


38,287.38
* Real Discount Rate = (1+Nominal Discount Rate)/ (1+Inflation Rate)-1
= (1+0.075)/ (1+0.04)-1
=3.3%

In these two methods it is not necessary that the result must be same .In above example NPV results are different so the management uses lower NPV as a more reliable result that is Rs. 37013.61

NPV will provide more accurate results in comparison to internal rate of return, payback period and accounting rate of return.

Calculations of NPV in excel:
A
B
1
Cash Flow

2
12000

3
18000

4
26000

5
32000

6
Rate
8%
7
NPV
INR 1,596.10

B7: “=NPV (8,A2:A5)”

In my next post we will discuss about Internal Rate of Return technique of capital budgeting.

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