Net present value (NPV)

NPV is an important term where you will see it in a lot of your FIA/ACCA papers. Its meaning must be understood in detailed. This article is intended to give an idea about NPV.

Definition
CIMA Official Terminology gives this technical definition: difference between the sum of the projected discounted cash inflows and outflows attributable to a capital investment or other long-term project. In simple words, NPV = present cash flows + future cash flows converted to present values.

Making decision
The decision criteria is to accept a project with positive NPV (but you must also consider non-financial factors such as legal requirement, social responsibility etc). This is because positive NPV project will be able to increase company's value and therefore shareholders wealth.
But what if NPV is zero? In this case, the project is still acceptable, why? This is because it means that the project will not increase/decrease company's value, but the project is still making profit (it can be loss as well). However, in practice management will not accept such project as it is not meeting the company's (stock market listed companies) financial objective of maximising shareholders wealth.

Other uses - F7/P2
The concept of NPV is used in other areas as well. For example, in financial reporting, the term value in use (IAS 36) means the discounted present value of the future cash flows expected to arise from the continuing use of an asset and from the disposal at the end of its useful life. This is actually the NPV of the asset (not considering investment cost). The concept of NPV must be understood and applied in other situations.

Discount rate
This is the rate to be used to convert the future cash flows into present value. For a project it is normally the company's cost of capital (required rate of return by investors of the capital). Therefore, to calculate NPV, you have to first estimate a relevant cost of capital (will be given in FIA papers). Present value table and annuity table will be given in exam, you have to extract the correct rates relevant for different time periods to be used to calculate NPV.

Finally, we can conclude that NPV considers relevant cash flows rather than profits (profits include non-cash items such as depreciation, provision). NPV also considers time value of money (therefore, cash flows in different time periods are discounted/converted to present value at different rates).