Net Present Value and Internal Rate of Return,

in short NPV and IRR. What is the purpose of the NPV and IRR methods of investment analysis, and how do you calculate NPV and IRR? The main idea of Net Present Value is very simple: time is money! The net present value (or “discounted cash flow”) method takes the time value of money into account, by: Translating all future cash flows into today’s money Adding up today’s investment and the present values of all future cash flows If the net present value of a project is positive, then it is worth pursuing, as it creates value

for the company.

Let’s perform a Net Present Value calculation

step-by-step. What is the present value (PV) of all the

cash inflows and cash outflows of the following project? Project A requires an investment of $1000

today (in year 0), and is expected to provide four years’ worth of benefits of nominally

$400 per year. The $1000 of investment is already in today’s

money: $1000 today equals $1000 today. What is the present value of a $400 benefit

that we expect one year from now? To calculate that present value, we need to

take the nominal amount of $400 and divide it by 1 + the weighted average cost of capital. Weighted average cost of capital (or WACC)

is a calculation of a firm's cost of capital in which each category of capital is proportionately

weighted. The riskier or more uncertain the company

and the riskier or more uncertain the project, the higher the WACC becomes.

Let’s take a fairly high WACC of 20% in

this calculation. 1 + 20% equals 1.2. $400 divided by 1.2 equals $333. The present value of a nominal amount of $400

one year from now is $333 as today’s equivalent. What is the present value of a $400 benefit

that we expect two years from now? To calculate that present value, we need to

take the nominal amount of $400 and divide it by 1 + 20%, to the power 2 (as we need

to take two steps: from year 2 to year 1, from year 1 to today). This is the same as saying $400 divided by

1.2 * 1.2, or $400 divided by 1.44, which is $278. The present value of a nominal amount of $400

two years from now is $278 as today’s equivalent. What is the present value of a $400 benefit

that we expect three years from now? To calculate that present value, we need to

take the nominal amount of $400 and divide it by 1 + 20%, to the power 3 (as we need

to take three steps: from year 3 to year 2, from year 2 to year 1, from year 1 to today).

This is the same as saying $400 divided by

1.2 * 1.2 * 1.2, or $400 divided by 1.728, which is $231. The present value of a nominal amount of $400

three years from now is $231 as today’s equivalent. What is the present value of a $400 benefit

that we expect four years from now? To calculate that present value, we need to

take the nominal amount of $400 and divide it by 1 + 20%, to the power 4. This is the same as saying $400 divided by

1.2 * 1.2 * 1.2 * 1.2, or $400 divided by 2.0736, which is $193. The present value of a nominal amount of $400

four years from now is $193 as today’s equivalent. We have now translated all cash flows into

today’s equivalent. To get to NPV, you now simply sum across,

and find an NPV of $35. As the net present value of this project is

positive, it is worth pursuing, as it creates value for the company.

How to calculate the Internal Return of Return

(or IRR)? IRR is the discount rate at which the net

present value becomes 0. In other words, you solve for IRR by setting

NPV at 0. We take the same project A, and write down

the formulas to calculate NPV. Through either trial and error, or the use

of the IRR formula in Excel, we will find that the IRR for project A is 22%. This IRR of 22% exceeds the Weighted Average

Cost of Capital of 20%, so the project is worth pursuing, as it creates value for the

company. What if we have multiple projects in our company

that we want to force rank? We only have $1000 of investment money to spend, which project is (financially speaking) the most attractive? In total, for the full 4 years combined, each

of the three projects has $1600 worth of cumulative benefits, but the timing of these benefits

varies: evenly distributed for project A, high benefits in early years shrinking to

lower benefits in later years for project B, and low benefits in early years growing

to higher benefits in later years for project C.

Applying the NPV and IRR methods can help! We already calculated that at 20% Weighted

Average Cost of Capital, the NPV of project A is $35. Its IRR is 22%. For project B, due to the high benefits in

early years that don’t get discounted too much by the time value of money, the NPV is

$117, and the IRR is 27%. For project C, due to the long wait for the

bigger benefits to come in, the NPV is negative at minus $46, and the IRR is 18%.

Project C is not worth pursuing, with negative NPV and an IRR which is below the Weighted Average Cost of Capital. Project B is the most attractive. I hope you enjoyed this short explanation

of the Net Present Value and Internal Rate of Return. If you enjoyed this video, then please give

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