Part Two Net Present Value Method Net present value (NPV) is one method that can be used to evaluate the financial viability of potential projects. It determines the present value of all future cash flows associated with potential projects and measures this against the cost of the project. To use net present value, a required rate of return must be defined. The required rate of return is the minimum acceptable rate of return that an investment must yield for it to make sense economically. Managers often choose a required rate of return above their cost of capital to ensure that the inherent uncertainties surrounding future cash flows is addressed. This can be risky, however, as it biases the process toward short-term projects. If the NPV is positive, then the project should be accepted ; if it is negative, then the project should be rejected. Let's look at a net present value example using the present value of an ordinary annuity table. The company has a project with a 5-year life that requires an initial investment of $200,000, and is expected to yield annual cash flows of $61,000. What is the net present value of the project if the required rate of return is set at 12%? Calculation Steps Present Value of an Annuity of $1 at Compound Interest. Net Present Value = ( $ 61,000 x ) Note: Round your answer to the nearest whole dollar. What NPV does the previous calculation yield? $ Based on the NPV computed above, what is indicated? 1. The project is profitable 2. Yes, the initial investment will be recovered. 3. Yes, the required rate of return will be recovered. 4. A positive NPV in excess of the initial investment and required rate of return has been achieved. Feedback Present Value Index present value index below 1.0. Also, it is important to note that a project with the largest When funds for capital investments are limited, projects can be ranked using a present value index. A project with a negative net present value will have net present value may, in fact, return a lower present value per dollar invested. Let's look at an example of how to determine the present value index. The company has a project with a 5-year life, an initial investment of $195,000, and is expected to yield annual cash flows of $56,500. Whathat is the present value index of the project if the required rate of return is set at 8%? Total present value of net cash flows Present value index Initial investment Calculation Steps Note: Round total present value of net cash flows and initial investment to nearest dollar. Round present value index to two decimal places. Present value index = 195,000
