Use Discounted Cash Flow Models to Make Capital Investment Decisions
Calculation and Discussion of the Results of the Net Present Value Model
To demonstrate NPV, assume that a company, Rayford Machining, is considering buying a drill press that will have an initial investment cost of $50,000 and annual cash flows of $10,000 for the next 7 years. Assume that Rayford expects a 5% rate of return on such an investment. We need to determine the NPV when cash flows are equal. The present value factor (i = 5, n = 7) is 5.786 using the Present Value of an Ordinary Annuity table. We multiply 5.786 by the equal cash flow of $10,000 to get a present value of $57,860. NPV is found by taking the present value of $57,860 and subtracting the initial investment of $50,000 to arrive at $7,860. This is a positive NPV, so the company would consider the investment.
| Present Value of an Ordinary Annuity Table | |||||
| Rate (/) | |||||
|
Period (n) |
1% | 2% | 3% | 5% | |
| 1 | 0.99 | 0.98 | 0.971 | 0.952 | |
| 2 | 1.97 | 1.942 | 1.913 | 1.859 | |
| 3 | 2.941 | 2.884 | 2.829 | 2.723 | |
| 4 | 3.902 | 3.808 | 3.717 | 3.546 | |
| 5 | 4.853 | 4.713 | 4.58 | 4.329 | |
| 6 | 5.795 | 5.601 | 5.417 | 5.076 | |
| 7 | 6.728 | 6.472 | 6.23 | 5.786 | |
Let's say Rayford Machining has another option, Option B, for a drill press purchase with an initial investment cost of $56,000 that produces present value cash flows of $60,500. The profitability index is computed as follows.
|
Based on this outcome, the company would invest in Option A, the project with a higher profitability potential of 1.157.
Now let's assume cash flows are unequal. Unequal cash flow information for Rayford Machining is summarized here.
|
Year |
Net Cash Flow |
|
1 |
$10,000 |
|
2 |
5,000 |
|
3 |
7,000 |
|
4 |
3,000 |
|
5 |
10,000 |
|
6 |
10,000 |
| 7 |
10,000 |
To find the overall present value, the following calculations take place using the Present Value of $1 table.
|
Year |
Cash Flow Amount |
Present Value Factor (i = 5, n = specific year) |
Present Value |
|
1 |
$10,000 |
(i= 5, /7 = 1) = 0.952 |
0.952 x $10,000 = $9,520 |
|
2 |
5,000 |
(i = 5, n = 2) = 0.907 |
0.907 x 5,000 = 4,535 |
|
3 |
7,000 |
(i = 5, n = 3) = 0.864 |
0.864 x 7,000 = 6,048 |
|
4 |
3,000 |
(i = 5, n = 4) = 0.823 |
0.823 x 3,000 = 2,469 |
|
5 |
10,000 |
(i' = 5, n = 5) = 0.784 |
0.784 x 10,000= 7,840 |
|
6 |
10,000 |
(i = 5, n = 6) = 0.746 |
0.746 x 10,000= 7,460 |
|
7 |
10,000 |
(i = 5, n = 7) = 0.711 |
0.711 x 10,000= 7,110 |
|
Total |
$55,000 |
|
$44,982 |
The present value for each period looks at each year's present value factor at an interest rate of 5%. All individual year present values are added together for a total present value of $44,982. The initial investment of $50,000 is subtracted from the $44,982 to arrive at a negative NPV of $5,018. In this case, Rayford Machining would not invest, since the outcome is negative. The negative NPV value does not mean the investment would be unprofitable; rather, it means the investment does not return the desired 5% the company is looking for in the investments that it makes.