Net Present Value (NPV) (Cambridge (CIE) A Level Accounting): Revision Note
Exam code: 9706
Net present value (NPV)
What is the net present value of an investment?
The net present value calculates the value of future cash flows in today's money by using discount factors
It accounts for the time value of money
A dollar received today is worth more than a dollar received in five years
Owners usually prefer investments which have a higher net present value
If the net present value is positive, then the project returns more than the cost of the capital
These projects are normally accepted
If the net present value is negative, then the project does not cover the cost of the capital
These projects are normally rejected
What are discount factors?
A discount factor tells you how money in the future is worth today
For example, a discount factor of 0.909 means $1in the future is worth $0.909 today
Discount factors are based on a discount rate
A discount rate of 10% means that the currency in any year is worth 10% more than the following year
It is assumed that the discount rate does not change between years
Examiner Tips and Tricks
You do not need to memorise discount factors or learn how to derive them. You will be given the relevant discount factors in the exam question.
How do I calculate the net present value?
STEP 1
Calculate the net cash flow for each yearSTEP 2
Multiply each year's net cash flow by the discount factor for that yearThe discount factor for Year 0 is always 1.000
STEP 3
Add together all the discounted net cash flows to find the NPVInclude Year 0
Examiner Tips and Tricks
Set out your calculations in a table to make sure each net cash flow is multiplied by the correct discount factor.
What are the advantages and disadvantages of the net present value method?
Advantages
It accounts for the time value of money
It considers all cash flows over the project life
It is the most accurate method in theory
Disadvantages
It requires a discount rate to be chosen
This can be difficult in practice
It is very sensitive to the chosen discount rate
It is more complex to calculate and explain to non-specialists
Worked Example
The directors of D plc are considering the purchase of a new machine, costing $220 000, to manufacture a newly developed product, Product Omega. The directors intend to manufacture the product for only four years, after which the machine will have zero residual value.
The directors have estimated the following net cash flows arising from the project:
Year | Net cash flow ($) |
|---|---|
1 | 45 000 |
2 | 60 000 |
3 | 105 000 |
4 | 30 000 |
The cost of capital is 10%. The discount factors for this are as follows:
Year | Discount factor |
|---|---|
1 | 0.909 |
2 | 0.826 |
3 | 0.751 |
4 | 0.683 |
Calculate the net present value (NPV) for the new machine.
Answer:
Multiply each net cash flow by the corresponding discount factor
The discount factor for Year 0 is 1.000
Year | Net cash flow ($) | Discounted net cash flow ($) | |
|---|---|---|---|
0 | (220 000) | (220 000) × 1.000 | (220 000) |
1 | 45 000 | 45 000 × 0.909 | 40 905 |
2 | 60 000 | 60 000 × 0.826 | 49 560 |
3 | 105 000 | 105 000 × 0.751 | 78 855 |
4 | 30 000 | 30 000 × 0.683 | 20 490 |
Add together the discounted cash flows
Year | Net cash flow ($) | Net present value ($) |
|---|---|---|
0 | (220 000) | (220 000) |
1 | 45 000 | 40 905 |
2 | 60 000 | 49 560 |
3 | 105 000 | 78 855 |
4 | 30 000 | 20 490 |
(30 190) |
Unlock more, it's free!
Join the 100,000+ Students that ❤️ Save My Exams
the (exam) results speak for themselves:
Was this revision note helpful?
