Learning Objectives of this
article:

Define and explain the net
present value method of evaluating capital
investment proposals.

How is it calculated?

What are advantages and
disadvantages of this method?
Contents:
Capital investment analysis is
concerned with comparing the initial cash investment
with a future cash flow stream. To make this
comparison, cash flows at different points in time
must be made equivalent. As a result, cash flows in
the future must be brought back to the present and
compared with the cash outflow for the investment.
This method is also known as discounted cash flow
method.
The net present value method
uses present value concepts to compute the net
present value of the cash flows expected from a
proposed investment.
The rate of return or interest factor, used in
present value analysis is determined by management.
The rate is often based upon such factors as the
nature of the business enterprise and its relative
profitability, the purpose of the capital
investment, the cost of securing funds for the
investment, and the minimum desired rate of return .
If the net present value of the net cash flow
expected from a proposed investment at the selected
rate equals or exceeds the amount of the initial
investment, the proposal is desirable.
Management is considering to acquire
equipment costing $2,00,000. The expected useful
life of the equipment is five years with no residual
value. The minimum desired rate of return is
10%.
The expected net cash flow for each
of the five years and the net present value of the
proposal is as follows:

Present 

1 
2 
3 
4 
5 









$(20,000) 

$70,000 
$60,000 
$50,000 
$40,000 
$40,000 









63,630 
× 
.909 













49,560 
× 

.826 












37,530 
× 


.751 











27,230 
× 



.683 










24,840 
× 




.621 








Net present value 
$2,900 















Year 
Present Value of $1 at 10% 
Net Cash
Flow 
Present Value of net cash
flow 
1 
.909 
$70,000 
$63,630 
2 
.826 
$60,000 
$49,560 
3 
.751 
$50,000 
$37,550 
4 
.683 
$40,000 
$27,320 
5 
.621 
$40,000 
$24,840 




Total 

$260,000 
$202,900 
Amount to be
invested 
$200,000 




Net present
value 
$2,900 





Explanation:
The present value of the net cash
flow for each year is calculated by multiplying the
net cash flow for the year by the present value
factor of $1 for that year. In above example, the
net cash flow of $70,000 to be received at the end
of year 1 is multiplied by the present value of $1
for one year at 10% (.909). Thus, the present value
of the $70,000, $63,630. Likewise, the net cash flow
at the end of the second year, $60,000, is
multiplied by the present value of $1 for two years
at 10% (.826) to yield $49,560, and so on. The
amount to be invested, $200,000, is then subtracted
from the total present value of the net cash flows,
$202,900, to determine the net present value,
$2,900. The net present value indicates that the
proposal is expected to recover the investment and
provide more than the minimum rate of return of 10%.
When many alternative capital
investments of the same amount are proposed and the
funds are limited, the proposal with the highest net
present value is preferred. If the alternative proposals involve
different amounts of investment, it is useful to
prepare a relative ranking of the proposals by using
a present value index. The present value index is
computed by dividing the total present value of the
net cash flow by the amount to be invested. The
present value index for above example is computed as
follows:
Present Value Index =
Total Present Value of Net Cash Flow /
Amount to Be Invested
= $202,900 / $2300,000
= 1.01 
To further illustrate, assume that
the total present value of the net cash flow and the
amounts to be invested for three alternative
proposals are as follows:

Proposal A 
Proposal B 
Proposal C 
Total present value of net
cash flow 
$107,000 
$86,400 
$93,600 
Amount to be invested 
100,000 
80,000 
90,000 




Net present value 
$7,000 
$6,400 
$3,600 









The present value index for each
proposal is as follows:
Present
Value Index 
Proposal A 
1.07 ($107,000 /
$100,000) 
Proposal B 
1.08 ($86,400 /
$80,000) 
Proposal C 
1.07 ($93,600 /
$90,000) 

Although Proposal A has the largest
net present value, the present value indexes
indicate that it is not as desirable as Proposal B.
Proposal B returns 1.08 present value per dollar
invested, whereas Proposal A returns 1.07. Proposal
B requires an investment of $80,000, compared to an
investment of $100,000 for Proposal A. Management
should consider the possible use of the $20,000
difference between Proposal A and Proposal B
investments before making a final decision.
An advantage of this method is that
it considers the time value of money. A disadvantage is that the computations are
more complex than those for the methods that ignore
present value. The net present value method assumes
that the cash received from the proposal during its
useful life can be reinvested at the rate of return
used in computing the present value of the proposal.
This assumption may not always be reasonable due to
the changing economic conditions.
