In basic term, net present value (NPV) of an investment is the difference between:
The present value of future cash flows and the present value of the initial capital expenditure required to implement the project.
Say for example the following project having the follow details:
| Year O | Year 1 | Year 2 | Year 3 | Year 4 | |
| Initial Outlay (a) | $100K | ||||
| Net cash-flows (b) | $20.00K | $30.00K | $40.00K | $50.00K | |
| Using NPV: | |||||
| PV Factor © | 1.000 | 0.909 | 0.826 | 0.751 | 0.683 |
| Present Value (a*c) or (b*c) | - $100K | +$18.18K | +$24.78K | +$30.04K | +$34.15K |
| Net Present Value | +$7.15K |
Interpretation of NPV:
If the project has a positive NPV, it should be accepted. By acceptance, it will increase the shareholders value as it gives a higher return compared to its cost of capital ( in this case is the PV factor or discount factor which we assume is 10%)
It’s important to understand that normally, a positive NPV implies excess returns over its cost of capital. But in economic theory, it will not happens in an efficient and competitive market as competitiveness will remove the opportunities to make excess returns from capital expenditures.
Of course in the real world, we have imperfection, however it’s interesting to note and rationalize the source of the positive NPV or the excess return. Is it from any superior technological expertise, R&D, trademarks and patents, market knowledge & skill, quality control, distribution network, after sales service and client relations or the caliber of management and employees? By identify the competitive factors that generate positive NPV , we are able to understand better the reasons for the project’s profitability.
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