The net present value method has become one of the most popular tools for evaluating capital projects because it reduces each project to a single figure: the total estimated value of the project, expressed in today's dollars. When evaluating two competing projects, you can compare their figures to determine which is more promising, and therefore the better choice to invest in.
To calculate the net present value, or NPV, of a project, you need estimates of the annual cash flows the project will produce, and a figure for your company's "cost of capital." The cost of capital is how much it costs you to use money for the project. If you borrow money, it's the rate of interest you'd pay. If you use your own money (or money from investors), it's the return you're sacrificing by not using that money for something else. You then use your cost of capital as your "discount rate" to adjust the estimated future cash flows to present value – what they're worth in today's dollars.
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Cost of Capital
Say you could borrow money at 6 percent annual interest, and you could earn an 8 percent return if you invested your own money elsewhere. If you borrowed all the money for a project, your cost of capital would be 6 percent – meaning it would cost you 6 cents a year for every $1 you use on the project. If you used only your own money, your cost of capital would be 8 percent. If you finance your projects with half borrowed money and half your own money, your cost of capital would be 7 percent: (0.5 x 6%) + (0.5 x 8%) = 7%. If you borrowed 60 percent of the money, your cost of capital would be 6.8 percent: (0.6 x 6%) + (0.4 x 8%) = 6.8%.
The formula for discounting a future year's cash flow to present value is: PV = CF / (1+r)^t "PV" is the present value; "CF" is the future cash flow; "r" is your annual cost of capital; and "t" is the number of years between now and the cash flow. So for next year's cash flow, t=1. For the year after that, t=2, and so on. If in three years from now, you estimate cash flow of $30,000, and your cost of capital is 6.8 percent, the equation to figure out the discount to present value is: PV = $30,000 / (1+0.068)^3 = $24,626.77
Evaluating Two Projects
To evaluate two competing projects, start by discounting all the future cash flows of each project to present value. The first year's cash flows – which will usually be negative, as they represent upfront investment costs – don't get discounted, since they're already at present value. Add up the present values of all the cash flows of each project. The result is each project's NPV. A positive NPV represents a money-making project. A negative NPV is a money-loser. If either project has a negative NPV, stop here. That project's not worth your time.
If both projects have a positive NPV, compare the NPV figures. Whichever project has the higher NPV is the more profitable and should be your first priority. Doing both projects is fine, since both will be profitable, but if you can do only one then go with the higher-NPV project. If the NPV figures are fairly close to each other, try dividing each project's NPV by its upfront costs. This gives you a value known as the "profitability index" – how much profit you will make for each $1 invested. If one project's index is much higher than the other's, go with the higher index to get more bang for your buck.