Net Present Value (NPV) and Profitability Index (PI) evaluate cash flows to assess the profitability of a project. Both methods represent future cash flows in present day dollars by discounting the cash flows with a required rate of return. This rate is subjective and may match the current rate of inflation, the rate of a less-risky investment or simply a desirable rate of return. The NPV calculation results in a dollar figure value, whereas PI offers a multiplier that shows how much more profitable the cash flows are with respect to the rate of return.
Net Present Value
1. Add one to the required rate of return, in decimal format. As as example, if you wanted to assess the profitability of new line of widgets, the endeavor would only be attractive if it offered more profit than a less-risky alternative investment. If that investment offered a 5 percent return on investment, then you would use 0.05 as the required rate of return. Adding 1 gives you 1.05.
2. Calculate the NPV of each future cash flow. This is done by raising the previous calculation to the nth power, where "n" is the number of years into the future the cash flow occurs. You then divide this result into the cash flow value. In the example, if you expect your new line of widgets to generate $5,000, $10,000 and $3,000 in the three years they are produced, you would raise 1.05 to the power of 1, 2 and 3, respectively. Dividing the cash flow values by these figures results in NPVs of $4,762, $9,070 and $2,592 for each payment.
3. Add the NPVs of each future cash flow to derive the total NPV for future cash flows. In the example, adding $4,762, $9,070 and $3,592 gives you a total of $16,424.
4. Subtract the initial investment from the total NPV of future cash flows. In the example, if the initial investment was $15,000, the NPV of the project is $1,424.
5. Assess profitability. If the resulting figure is positive, then the venture is more profitable than the alternative investment, or exceeds expectations of a required rate of return. If the NPV is negative, then the project is less profitable. In the example, a NPV of $1,424 means you should undertake the project.
1. Calculate the total NPV for future cash flows, as described in the Net Present Value section. In the example, this offers a NPV for future cash flows of $16,424.
2. Divide this figure by the initial investment. In the example, $16,424 divided by $15,000 gives a PI of 1.095.
3. Assess profitability. A PI greater than 1 means the venture is more profitable than the alternative investment. A PI less than 1 means it is less profitable. In the example, a PI of 1.095 means the new line of widgets would be 1.095 times more profitable than the alternative investment, or the required rate of return.
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