Business managers use net present value methods to determine whether a large-scale project is worth implementing. A common method used when figuring net present value is to discount a series of cash flows and subtract them from the project's initial cost. Net present value can be used to figure out a project's internal rate of return, which is the percentage amount that an investment will yield over its initial cost during a specific time period. The cash flows used to determine net present value may include all known streams of income, variances between two or more projects' expected income, or estimated ranges of acceptable income.
One of the most widely used net present value methods takes a series of known cash flows and discounts them to their present value. For example, a capital project involving the expansion of a manufacturing facility may have known streams of income over the next five years. The company's expected rate of return is used to discount each stream of income to what it would be worth at the start of the project. Each cash flow's present value is added to the others and then subtracted from the project's initial investment cost to reveal whether the project should be accepted or rejected.
Net present value methods can be used to figure a project's expected rate of return when it is unknown. The internal rate of return (IRR) method reveals if a project will yield the minimum rate that investors are willing to accept. For example, some financial institutions will not lend to businesses that cannot demonstrate a certain rate of return within three to five years. The rate of return is the percentage of profit that a capital project or investment will earn on top of the initial cash outlay during a specific time period.
When potential investments are being compared, one or more net present value methods may be used. All known future cash flows may be used to figure out which project has the higher net present value. A more efficient comparison involves discounting the cash inflows and outflows that differ between the investments. With this method, the project with the highest net present value is the one that typically gets implemented.
At times it may be difficult to estimate an investment's future cash flows. One of the net present value methods involves using the break even concept. A particular range of future cash flows is discounted to the present value and compared against the investment's initial cost. Using this method, a break even point is usually determined and used to accept or reject the project.
