But I need to be able to explain it to people.

I can explain this; NPV is a way of assessing differet projects over different time periods. It helps pick and choose what goes into your project portfolio. It helps understand whether the project meets the opportunity cost thresholds your organisation has set.

And the calculations themselevs are easy enough once you know how to use the excel NPV feature.

But explaining it still stumps me. This is me having a go.

Someone - Help me out and do a better job.

Capital budgeting decisions fall into two broad categories: screening and preference decisions. Screening decisions relate to whether a proposed initiative passes a predetermined hurdle, minimum return for example. Preference decisions, on the other hand, relate to choosing from among several competing alternatives.

ReplyDeleteAn investment typically occurs early while returns do not occur until some time later. Therefore the time value of money, or discounted cash flows, should be accounted for. There are two approaches to making capital budgeting decisions using discounted cash flows: NPV and IRR. NPV is preferred for screening decisions and IRR is preferred for preference decisions. There are other methods used for making capital budgeting decisions such as Pay-Back and Simple Rate of Return. Neither method is recommended, as Pay-Back is not a true measure of the profitability of an investment while Simple Rate of Return does not consider the time value of money.

Under the NPV method, cash inflows are compared to the cash outflows. The difference, called net present value, determines whether or not the investment is suitable. A company’s cost of capital is typically considered the minimum required rate of return. This is the average rate of return the company must pay to its long-term shareholders or creditors for use of their funds. Therefore, the cost of capital serves as a minimum screening device.

There are often many opportunities that pass the screening decision process. The bad news is not all can be acted on. Financial or resource constraints may preclude investing in every opportunity. Preference decisions, sometimes called rationing or ranking decisions, must be made. The competing alternatives are ranked.

The NPV of one project cannot be directly compared to another unless the investments are equal. As a result, the IRR is widely used for preference decisions. The higher the IRR, the more desirable the initiative. The IRR, sometimes called the yield, is the rate of return over the life of an initiative. IRR is computed by finding the discount rate that equates the present value of a project’s cash outflows with the present value of its inflows. That is, the IRR is the discount rate resulting in an NPV of zero.

The NPV method has several advantages over the IRR method:

- NPV is generally easier to use

- IRR may require searching for a discount rate resulting in an NPV of zero.

- When NPV and IRR disagree on the attractiveness of the project, it is best to go with NPV. It makes the more realistic assumption about the rate of return.

Well, Thanks Michael!

ReplyDeleteWell, I looked through your slides (nice deck, by the way), and actually thought you'd done a pretty good job! Sounds like you know what you are talking about.

ReplyDeleteI would say that NPV has a use where you are not using ROCE (return on capital employed), although it's a useful project budgeting measure regardless.

I would explain it by saying thta NPV works out today’s value of all future cash flows generated with a discount rate of x%. The answer comes out in £ (or whatever currency you work in) and when I do it it's worked out over a 5 year timeframe.

The first year (year 0) is the initial investment year, where you say what you are spending. For years 1-5, calculate what is generated cash flow and any ongoing associated costs eg training.

Shove the numbers into Excel which calculates the answer. You're hoping for a positive number that beats your company's x% hurdle, which will help you get prioritisation for this business case.

Not sure if that makes sense to anyone else, but it makes sense to me!