How to evaluate the convenience of an investment: Net Present value (NPV) method


Author: Emanuele Crisafi

Connect with Emanuele Crisafi

Date of Publication: 10/08/2022



"Is it convenient to undertake an investment?" This is the first question anyone asks when they have money to invest. Everyone asks this question because the typical goal of an investment is to give up a sum of money today and get a larger one in the future. When we talk about investment, we can refer to a vast typology of investments:


● the underwriting of shares on the stock market,

bonds,

crowdfunding operations;


Beside these financial investments, there are also other investments that concern. For example, the development of a new business, the construction of a building or the purchase of a machine. Valuing an investment is an operation that requires the use of specific valuation methods and there are several ones:


● Payback Period (PBP),

● Internal Rate of Return (IRR) or

● Net Present Value (NPV).


Among these methods, the most used in finance is the NPV. This is because it is less characterized by calculation defects and approximations.


Coins and Net Present value (NPV) method

NPV: how does it work?

The Net Present Value (NPV) is defined as the value that a series of future cash flows have today. This is the result of investing a sum of money today. In other words, it indicates to the investor if the investment creates richness and therefore it is convenient. Otherwise, it destroys richness and as a result it is inconvenient. Mathematically it can be calculated using an easy formula:



Hence, to calculate the NPV it is necessary to determine:

- that is the initial investment, i.e., the sum to be paid out to start the investment

- that are the cash flow i.e., the monetary income that the investment will realize during the year 1,2,3 ...n

- is called the discount factor because it is a quantity that allows you to "convert" the value of a future sum of money into the corresponding today's value. This is based on an important principle of finance according to which time has a financial value and this is the reason why 1 € owned today is worth more than 1 € owned tomorrow.[1] Regarding the quantity k ,it is called opportunity cost of capital, i.e., the expected return using our money in an alternative way. For example, instead of launching a new business, we can use our money to buy shares that guarantee a rate of return of 10%).


After calculating the NPV, if its value is positive (>0) then the investment is convenient.


A practical example


Suppose you have to make an investment for a new business that concerns the opening of a company and requires an initial sum of € 20,000. In the 5 years of life, the company will make it possible to collect € 6,000 per year and the opportunity cost of capital is 6.5%. So:



The NPV is positive (4934€) so the investment is convenient: it means that you should launch this new business.


Now it’s your turn to evaluate the convenience of your investment using the Net Present value (NPV) method. Don’t hesitate to contact our Vision Factory team to get useful advice and guidance.


 

Reference list:


This article is a result of the university classes in corporate finance lectures attended by the author.

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