What is Net Present Value? (also called discounted cash flow method) is an excellent alternative to the current income tax planning method. It utilizes discounted value of an investment project to estimate the capital cost of such an investment. The method is highly useful for short-term investments as well as long term investments.
Net Present Value (NPV) is basically the amount to be gained from an investment project at the end of its life. It is equal to the annualized return on your initial investment. The calculation of NPV simply involves calculating the amount to be earned minus the amount to be lost or spent during the period of investment. Net Present Value is very important in any financial plan, as it helps you make a decision whether to buy or sell particular securities.
A company’s net present value is an estimation of what they would earn if they invested the funds in different investment projects. It basically involves calculating the present value of future cash inflows less expected losses on investment projects. The calculation involved in the NPV method is done by dividing the present worth of inflows by the total expected losses. A negative sign indicates that the inflows are expected to exceed the losses.
Basically, the net present value index indicates what the company can expect to earn in the long run by investing the monies in desirable investment projects. It is often used as one of the factors to determine the profitability of any given venture. This is so because the amount of profits realized as a result of investing in projects is directly proportional to the level of net present values. Thus, it enables companies to determine what projects should be pursued and which should be abandoned.
The first step in using the net present value method in evaluating an investment proposal is the analysis of what is the current cash inflow. The second step is the comparison of this cash inflow with the amount of profits that can be realized through investment projects. It is important to note that this analysis considers the entire lifetime of an investment project. The third step is then done by calculating the level of net worth using the cash inflows and the expected losses through the investments.
The fourth step in the evaluation of an investment proposal is the evaluation of the level of return. The fifth step is the analysis of the level of risk. The analysis of expected returns and level of risk is necessary in order for the smart manufacturing company to decide whether to pursue a particular project or not. There are two types of benefits associated with the use of the net present value method – the benefit and cost benefits. These are known as external rewards and internal rewards.
An alternative to the use of the net present value index is the use of financial projections. This is where a company will make projections on how the company’s sales, operating, and investing activities will affect the net worth of the business over the long or short term period. This is usually based on historical sales trends. A company can also use the analysis on its own or use the input data from the study and generate a personalized financial projection that will be most suitable to the needs of the company.
The main reason why the net Present Value of an investment proposal should be considered is because it gives investors an idea as to what the value of a future asset will be after all the expenses and revenue have been calculated. So what is Net Present Value then? Net Present Value can be defined as the value that a future asset would have when compared to the value at the present moment of the cash inflows or outflows of an investor. This can be viewed in different ways. It can be in terms of discounted cash inflows or discounted gross revenue. For example, the NPV of an equity investment proposal would be the amount that the investors will receive minus the amount they will have to pay (net present value) at the end of a period of time.