Evaluating return of an investment opportunity: Net Present Value

When you are offered an opportunity to invest in any project, it is important to be rewarded for the risk undertaken by investing the time and money.   Return can be seen as the money you make or lose over a certain period of time.  Positive return on investment is always the main objective of any investment.  In this article, I will explain a basic idea on how to evaluate return on investment, namely Net Present Value (NPV).

At the very least, an investment should create future cash inflows to reward the investor.  These cash flows should be compared to the initial investment amount.  The most accurate way to weigh the future cash flows against the initial investment amount is by calculating the NPV.   

The NPV calculation takes into account the time-value of money, which means that a dollar today is worth more than a dollar in the future, because the dollar of today can be invested.  Before investing, the investor should decide which rate of return would suffice to reward him/her for his/her investment.  This return can be, for example, inflation plus 1% per year.  This required rate of return, r, is the rate which the NPV calculation uses to discount the future cash flows.

Once you know the initial investment which is required for a project, and you have determined the required rate of return, you should estimate expected cash flows over the investment horizon.  Cash flows could be, for example, as follow:

Year     Amount         Inflow or Outflow

0             -$100 000         Outflow of initial investment

1             $30 000         Inflow

2             $30 000         Inflow

3             $30 000         Inflow

4             $30 000         Inflow

5             $30 000         Inflow

The NPV calculation is a follow:

Let us assume that your required rate of return is inflation (6%) plus 1%.  The discount rate of the NPV calculation would be 7%.  This investment’s NPV would be as follow:

The positive NPV means that this particular investment would be rewarding for the investor, and should yield a positive return, which will be more than the expected 7% per year.  A NPV of zero means that your investment return and required rate of return is the same.

Investors should always invest in projects that yield a positive NPV.  If an investor should choose between projects with positive NPVs, the investor should use the profitability index as a measure of profitability.  The profitability index (PI) is simply:

The higher this number, the more profitable the investment is.

The use of NPV has the advantage of accounting for the time-value of money.  Another advantage of the NPV method is that unequal cash flows can also be used to calculate a NPV.  Projects that yield a positive NPV should be accepted, if not mutually exclusive, then ranked by the profitability index.  Projects with a NPV of smaller than zero, should be rejected.  It is always important to also consider qualitative considerations too, because, for example, the investor might have an ethical consideration regarding a certain project, even though the project has a positive NPV.