Net Present Valu1

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Southwestern College, California *

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Finance

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Feb 20, 2024

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Net Present Value (NPV) The net present value (NPV) is the most commonly used capital budgeting technique currently in use. It addresses the inherent weaknesses associated with the payback period and presents its findings as a monetary amount rather than time or percentage. It is particularly useful when screening projects, but less effective when ranking projects, especially when the projects have different projected lives or vastly different initial investments. The NPV is determined by netting the present value of the operating cash flows against the initial investment. The rate used to discount the operating cash flows to their present value is typically the firm’s cost of capital or a more-aggressive required rate of return. One of the reasons NPV is popular is because it has a universal or generally accepted decision rule: If the NPV is equal to or greater than 0, the project should be accepted for further consideration; if the NPV is less than 0, it should be rejected. Projects with NPVs equal to or greater than 0 are expected to provide returns that are equal to or greater than the firm’s cost of capital or required rate of return and therefore maintain or increase the overall value of the firm. The net present value (NPV) formula discounts all cash flows from a project back to the original investment to determine if the investment will net a profit. If the NPV is greater than $0, it will be added to the company’s bottom line. The major use of NPV is to help choose between two projects when cash flows are scare and there can only be one chosen. The higher the NPV, the easier to choose the product. There are two ways to calculate NPV in Excel. You can use the following NPV formula: =NPV(.10, value, value,…) The Brenswick-Halter Case After a short break, Marshall returned to the conference room to see that Bill and Selma had already prepared a 7-year forecast of operating cash flow for the project in MS Excel and projected it onto the main screen.

This was the first time that Marshall had the opportunity to see the entire set of cash flows summarized on one slide. Marshall recalled from the night before, as he prepared for this part of the project analysis, how important and commonly accepted the NPV approach was. Because of its comprehensive nature and formal decision rules, it was considered one of the most reliable and used capital budgeting techniques. He knew that if the project failed the NPV test, his team, for all intents and purposes, was done. To calculate NPV, the corporate had instructed that they use a discount rate of 15 percent as its required rate of return when discounting the operating and terminal cash flows. When this step was complete, the discounted project cash flows would be netted against the project’s initial investment. If the result was equal to or greater than 0, the project would have passed the NPV test and should be accepted for further consideration. If the result was negative, less than 0, the project would have failed the NPV and therefore, should not be accepted. Using MS Excel, Selma calculated the present value of the project’s operating and terminal cash flows. Selecting the Formulas tab, she clicked the Financial icon, which revealed a pull-down menu. She followed the menu down until she located the function titled NPV . When she clicked it, a dialog box appeared. The first value it required was the Rate. For this value she entered “0.15,” the discount rate that corporate had recommended they use for the project. She made sure that the value was entered as a decimal rather than a whole number.

Next, the model asked her to enter Value1 . She knew from previous applications of this model that Value1 was the first year’s operating flow, not the initial investment. She also knew that she could either enter the value directly or type in the location of the cell that the value was in. She chose to enter the address of the cell, just in case the information related to the project changed. For Value2 , she entered the location of the Year 2 operating cash flow and continued this process until all of the boxes, including Value7 , were filled. Satisfied that all of the data were entered correctly, she clicked on the OK button. Initially, the team was astonished by the result. The NPV Function indicated that the NPV of the project was $177.836 million, well above the required threshold of 0. Bill was the first to question, “What about the initial investment?” Bill was right. Even though the function called itself NPV , it really only calculated the present value of the operating and terminal cash flows. To actually calculate NPV, the amount needed to be netted against the initial investment. Selma created a cell in the spreadsheet, netted the two amounts, and the result was now an NPV of $27.836 million. Even after this adjustment, the project still had an NPV greater than 0.

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