NPV is an excellent measure of business value but its calculation can be quite complex. This paper outlines a few rules which will lead to a ‘CFO-friendly’ value measure and avoid potentially embarrassing questions about how the answer was obtained. When the business case ultimately reaches board level it is important that the correct method has been followed to quantify the value which will meet the board’s requirements. In this paper we examine some of the common sources of error and confusion and discuss the technique used in Shark software which avoids these errors.
Net Present Value is a measure of the future overall net profit from a project or solution converted and expressed in today’s value (currency) terms. When considering an investment it is very useful to know how much value is going to be returned and NPV is the key measure for this quantified value approach.
For any investment most of the delivered value will be generated in the future and a mathematical technique called ‘discounting’ is used to calculate and convert this future value into today’s terms. If you doubt that future cash is worth less than the same amount today, ask yourself which would you rather have: $100 today or $100 in a year’s time?
A simple example will demonstrate the calculation of NPV:
Spend $90 today Receive $110 in twelve months
In cash terms there is an overall net profit of $20 but that $20 is only received in a year’s time so we have to find out what that future receipt would be worth today. This is where the mathematical technique of discounting applies (note that we are not talking about discounting the sales price here!).
When a business spends money there may be many alternative uses for those funds. One obvious use might be to deposit it in the bank and earn interest but businesses must generate more than bank interest otherwise there would be no point being in business. If the business needs to earn a minimum 10% on investments that it is considering then, by applying 10% as the revaluation ‘discount rate’, the value in today’s terms of the $110 in one year’s time is $100. An alternative way of looking at this is that the business would have to put $100 in the bank to receive $110 in one year’s time if the rate of interest offered were a fixed 10% per annum.
$110 in twelve months is worth $100 today at a ‘cost of money’ of 10% therefore, in this example, the NPV is $100 less the initial investment of $90 leaving a net profit in today’s terms of $10.
The technical term ‘discount rate’ is often referred to as the company’s minimum return rate or hurdle rate.
A financial measure of whether a proposal delivers a profit or a loss using an annual cost of money applied to the timing of spend and savings. It includes the initial cost of the equipment / services, the monthly cost of maintenance, compared to the financial benefits accruing. The result is the change in shareholder value to be anticipated from project acceptance.
NPV is part of the family of ROI measures which also includes Internal Rate of Return (the annual rate of profitability of an investment) and Payback (the time taken to repay the initial investment).
With an internationally recognised method of calculation defined by the finance community you can rely on NPV to be solution independent. This means that in a sales environment all you have to worry about is whether the size and timing of the costs and the benefits have been described correctly.
When comparing the profitability of different investments, the valuation and timing of the various cash inflows and outflows is critical. A simple comparison of total benefits generated minus the total costs incurred does not allow a true value comparison. Take the following examples:
Spend $100 today Receive $120 in twelve months Cost of money 10%
NPV in this example is $9.09
Spend $100 today Receive $120 in six months Cost of money 10%
NPV in this example is $14.42
As we can see, the NPV depends heavily on the timing of the receipt of the $120 benefit. The sooner the benefits are received the higher the NPV. This actually gives us an advantage when using Shark to produce an NPV because all benefits (and costs) are individually profiled on a monthly basis making the NPV very accurate. The added benefit of using Shark to profile the benefits is that customer sponsorship is easier if the start date for a benefit can be adjusted to suit the real world onset of that benefit. Customers are reluctant to sponsor a 'general year 1 saving'!
Example 4 represents the simple example of a $100 investment which recoups $120 at the end of 12 months. Note that the correct NPV ($9.09) is only obtained if the initial investment is subtracted from the result of the Excel NPV function. Also, if we try and recreate Example 2 where the $120 is received in month six we find it is simply not possible in Excel.
A simple NPV in Excel
By only counting benefits at the end of the year there is the likelihood that the NPV will be understated and that may lead to problems with project approval at board level.
Counting the benefits for longer
If the investment were to bring equal values of $120 in subsequent years, the NPV would of course be much greater (but would still be undervalued using Excel):
This illustrates how important it is to count as many benefits as possible. The longer the benefits continue for, the greater is the NPV.
In Shark every single benefit Evaluator (same for the costs) creates its own individual monthly cash flow. As we have highlighted above, this timing information is important when gaining customer sponsorship because a delayed benefit is easier to support than one which is claimed to start immediately.
You can see an individual Evaluator cashflow by clicking on the icon highlighted.
Note that the average monthly savings are 685 x 30/36 = $571
It is sometimes tempting to try and recreate the NPV from Shark in Excel but because of the lack of timing detail this is not possible. Rather than trying to compress Shark to conform to Excel by working out annual values, the above monthly cash flow really needs to be operated on to give the true NPV. But as we have seen Excel does not have the true monthly NPV valuation function so this is not really an option.
Shark is much more capable and flexible than Excel so it is easier to work back from Excel if you have compressed the numbers into yearly values. In this instance, the NPV produced by Shark will match the Excel but the NPV result will inevitably be wrong because the monthly timing information is not included.