Net Present Value (NPV)
If you have studied introductory finance NPV will be one of the key concepts you would have learned about. So, it is important to make sure you understand it well. NPV allows you to evaluate future cash flows substantiated on the present value of money. In other words, it is about taking a project or an investment (such as a company) and asking – how can we evaluate it in term of cash flows?
What is the Net Present Value?
It is the present value of a sum of money, in contrast to some future value it will have when it has been invested or used for a project. The present value allows us to determine how much future money (say three years after investing it) is worth today. The example that is often given for this is whether you would prefer your $100 now or a $150 in the future.
What is it used for?
An NPV allows us to compare projects and investments over time looking at the cash flows. It also allows us to analyse the profitability of a projected investment. Consequently, we can assess the attraction of an investment using benchmarking of NPVs. If you want to improve your knowledge of benchmarking you can look at this case interview. Based on the risk that you want to take it allows you to decide how to invest money. It will often be used for this purpose when your client is planning to buy a company.
How to calculate NPV?
The formula that you will see may vary slightly depending on the consistency with which returns are generated. For the purposes of this, we will assume that every period of time generates the returns in equal amounts.
PV is the present value
FV is the future value
i is the decimal value of the interest rate for a specific period
n is the number of periods (usually years) between present and future
The Net Present Value is then calculated by adding the present values together as pictured below:
NPV calculations (especially the long ones) can get quite complicated. As a result, it is unlikely that you will be asked to do one of those in a case interview. However, check out one of our case interviews to learn how to deal with this. When you are working as a consultant you will be able to use excel or an NPV calculator for this and it becomes quite simple. However, if you are asked to do a calculation in a case interview there are some things you should bear in mind that will make it easier for you.
One of the key difficulties of this approach is the selection of the most appropriate discount rate. The discount rate refers to the interest rate used in discounted cash flow analysis to determine the present value of future cash flows. If the wrong discount rate is chosen it may lead to valuable projects and investments being rejected. The general rule of finding the right discount rate is that the bigger the risk (of the project or investment) the higher the discount rate. When you are doing your case interview you can ask for a discount rate directly. If you are told to estimate one then bear in mind that discount rates for secure cash-streams are usually set between 1% and 3%, however, for most companies, you use a discount rate between 4% and 10%. This is slightly different when you are calculating the NPV for a speculative startup in which case the discount rate can be a lot higher. When you are calculating the NPV for a company the general rule is to set the discount rate somewhere between 4% and 10%. It may be safer to use a number from a top end of this bracket.
Summary:
In summary, you will usually use NPV to calculate the value of a project or an investment on its future profits. This is why it is usually used to evaluate a company. It also allows you to compare different investments in a qualitative way by evaluating future cash flows in today’s time value of money. Whilst the method is extensively used due to the benefits of its applicability it is not without drawbacks. The method can be quite complicated meaning that users may find it difficult to use and understand. The NPV is also very sensitive to the initial investment cost. However, this method provides with a thorough decision-making mechanism as projects with a negative NPV are most likely to be rejected on that basis. Whilst this is not a perfect decision-making mechanism for the reason outlined above it is by far one of the most useful and widely used.
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