1.13 Net Present Value (NPV) (continued)
Let’s try another.
Example 2: “Uneven and Declining Cash Inflows”
Given: k = As above, except the cash inflows are reversed.
Solution: Fill in the appropriate data below.
| Year | Cash Flow | PV Factor | PV of the Cash Flow |
| 0 | |||
| 1 | |||
| 2 | |||
| 3 | |||
| 4 | |||
| 5 | |||
| NPV = |
Questions:
- Will the NPV increase or decrease relative to the prior example?
- How does the NPV method deal with each of the “critical methodological issues” outlined above?
Cost of Capital: You will recall that, in discussing the “free cash flow” formula earlier, we intentionally ignored interest expense, as it is a capital (and not an operating) cost, the latter of which we said we would use later as the discount rate. Well, here we did just that! The projections we have used herewith as a given, or starting point, have been operating cash flows, operating (accounting) profits, or Free Cash Flows (depending on who is doing the analysis) however defined. Such projections exclude capital and other non-operating costs. The analyst just “spreads” the cash flow projections based on what he understands the future business prospects of the project to be, which are then imported into one or another Capital Budgeting technique.
The discount rate used for the NPV calculation is a combined, or average, capital cost figure including debt and equity. Under the section somewhat below, we will mathematically define “cost of capital,” but for now the discount rate will be treated as a given. Again, suffice it to say for the moment, that the firm’s cost of capital is a kind of average of all the firm’s capital costs, including debt and equity.
The NPV method has two principle deficiencies, which we – eventually – will have to resolve:
- It does not provide us with a Rate of Return, which is more commonly used in Finance.
- Most people, even business executives, do not understand discounted present value.