What is Net Present Value?
Project will almost always (or at least they should) have a promised benefit or return to project investors which will be realised over time as the project delivers value.
As mentioned in the glossary article for Cost Benefit Analysis (CBA), comparison of investment options when determining which projects to prioritise will usually come down to which initial cost will deliver the greatest return.
While CBA will provide a basic formula to determine the difference between cost and benefit, the assumption in that analysis that today’s value and future value are the same is flawed. That is why, as an additional process step within CBA, Project Managers should determine the Net Present Value or NPV of a future benefit. Establishing NPV allows a project manager to convert all values in the calculation to today’s (present) value.
In other words, it allows stakeholders to compare apples with apples and make an informed decision based on accurate data.
Net Present Value Formula
The NPV calculation can be expressed using the following formula:
The NPV Formula is made up of the following inputs
- NPCF = Net Period Cash Flow
- Discount rate = This can be the market interest rate that could be expected if the Ideally this is set by the organisation so a Project Manager should consult the corporate finance team to determine what this is. For most project investments, a company might choose to use the weighted average cost of capital (WACC) as a discount rate, which is the average cost the company pays for capital from borrowing or selling equity.
- n = number of cash flow periods
While not part of the NPV formula, the initial project investment outlay should also be known to determine if the NPV is positive or negative.
In order for the Project to be considered for approval, the Net Present Value should be positive (the present value of a future benefit is greater than the investment). A negative Net Present Value would mean that the project cannot provide a positive return. A negative NPV does not always mean a business case should be rejected (for example a compliance project may have a negative NPV) but a positive NPV will seem far more attractive when determining how to allocate scarce investment dollars.
Net Present Value Calculation Example
A project submits a business case seeking a 100,000 initial investment to develop a new product.
- The product development will take a year (year zero) with sales revenue expected to occur for three years once released (years 1, 2 and 3).
- The cash flow from sales is expected to be 50,000 per year in year 1 and year 2 with demand reducing the benefits to only by 25,000 in year three.
- The discount rate used by the project organisation is 3% or 0.03
- The Project Manager must weigh the value or discount each cash flow which is done using the formula PCF (Period Cash Flow) / (1 + i)^n. Note that ‘^’ is ‘to the power of’.
- Applying this formula to our example gives yearly discounted cash flows of (rounded) 48,544 in year 1, 47.130 in year 2 and 22,879 in year 3.
- To get the total NPV for the Project, the Project Manager must sum up all the discounted cash flows for all periods which is 48,544 + 47,130 + 22,879 = 118,552
- As a final step to determine if the NPV is negative or positive as an indicator of the strength of the business case, the Project Manager subtracts the initial cost from the NPV which for this project is 118,552 minus 100,000 = 18,552
How to use Net Present Value for your projects
Ideally, as mentioned, your organisation has set the discount rate however if that is not the case, a simple replacement would be how much interest would you earn on the investment dollars if placed in a bank account instead of funding the project.
The best use of NPV in Project Management is in the business case stage where it can provide stakeholders a clear metric for determining if an investment is with making or not. In organisations which have multiple projects in a portfolio and have to carefully choose which projects to prioritise for allocation of scarce investment budget, NPV provides a way to do this.
Net Value FAQs
What is NPV?
NPV in project management is an acronym for net present value which is a metric that helps determine the profitability of investment.
What is net present value?
Net Present Value (NPV) or Net Present Worth (NPW) is a capital budgeting method used as part of a Cost Benefit Analysis (CBA) to determine the profitability of an investment. Net Present Value allows project stakeholders to determine if future benefits are more or less than the initial investment.
What does negative net present value mean?
A negative Net Present Value would mean that the project cannot provide a positive return. A negative NPV does not always mean a business case should be rejected (for example a compliance project may have a negative NPV) but a positive NPV will seem far more attractive when determining how to allocate scarce investment dollars.