What is Net Present Value?
The net present value (NPV) refers to the discounted present value of future cash flows (positive and negative) from an investment for a specified period (usually until maturity).
In simple words, it is the sum of all future cash flows discounted to the present terms. In practice, it is the difference between the cash inflows and outflows arising from the same investment, both discounted in present value terms.
NPV is a widely used method for investment appraisals, project cash flow forecasts, capital projects, new ventures, and company valuations.
It helps in cash flow planning and forecasting. Businesses can manage cash inflows and outflows by using NPV and decide the outcome of an investment opportunity in advance.
NPV uses a discount rate to bring future cash flows into present terms. It is a tool to analyze all future cash flows and present cash flows with the same parameter.
How to Calculate NPV?
NPV of an investment or project can be calculated by setting a discount rate and bringing all future cash flows to the present term.
The formula to calculate NPV can be written as:
A simpler form is:
NPV = Net Cash flows in present value terms – Initial Investment
Here are a few simple steps to calculate NPV.
The first step is to set the time horizon for all future cash flows. It must be carefully determined so that all relevant cash flows are included in the calculations.
You can set the discount rate and initial investment in this step as well.
The second step is to calculate all future cash outflows and inflows in present value terms.
Each cash flow can be brought to the present value terms separately.
In this step, you should calculate the net cash flow for investment. It is the cash outflows minus cash inflows.
Finally, you can calculate the net present value by deducting the initial investment from the net cash flow amount.
Importance and Uses of NPV
A positive NPV means an investment is beneficial for the investor. So, NPV can be used as a simple litmus test to appraise an investment proposal.
It helps businesses compare investments, cash flows, and securities. It means the same method can be applied across several types of analyses used by a business.
A business can use NPV analysis to compare different investment opportunities. All positive NPV investments can then be compared to choose the best opportunity.
It usually uses WACC as the discount rate calculated by the company in its other financial metrics as well. Hence, it is easier to calculate and evaluate investment options.
Although NPV does not rank investments, analysts can use it for comparison and rankings as well. Merely a positive NPV with a small dollar value cannot suffice an investment appraisal.
What is Return on Investment?
Return on investment (ROI) is a profitability measure to determine the profitability or returns generated by an investment.
It is a widely used performance measurement metric for profitability and efficiency analysis. It provides a simple way of analyzing investment options in a ratio or percentage term.
ROI can be used for profitability and for comparing different investment opportunities. It is a simple method of deducting investment costs from investment gains in percentage terms.
ROI can be used statically as a standalone figure or it can be converted into annualized ROI figure. For its simplicity, it can be used in conjunction with other performance measurement metrics like NPV or ROR.
How to Calculate ROI?
ROI uses a simple formula to calculate net gains on an investment.
Or a simple formula can be used:
ROI = (Net Gain/Total Investment) × 100
We can calculate ROI in a few simple steps.
The first step is to set the time horizon of the investment. It can be set from beginning to maturity in annualized terms as well.
The second step is to calculate the initial investment and relevant investment costs.
Relevant investment costs can be indirect investment expenses like transaction costs, financing costs, etc.
The next step is to calculate all investment gains. These are cash inflows arising from the investment within the set time horizon.
Finally, we can use the formula to calculate the ROI in a ratio or percentage term.
This optional step can be used to convert the ROI into annualized ROI by using the following formula:
Annualized ROI = (1 × X) t – 1
Here X = annualized return and t = time horizon
Importance and Uses of ROI
ROI is one of the most commonly used profitability measures to appraise investments. It is a simple financial term that is widely understood by managers.
Calculating ROI is simple and can be used in annualized percentage terms for better comparisons. It gives a simple tool to managers for comparing different investments with the same initial outlay and time horizon.
It can also be used for project appraisals with consistent cash outflows and inflows. However, for inconsistent cash flows, it should be used in conjunction with other metrics such as NPV.
ROI can be used as a starting point for complex investment appraisals along with NPV and other financial performance metrics as well.
Analysts must carefully include relevant investment costs though. For instance, appraisal of a stock investment should include dividends, capital gains, transaction costs, and interest costs.
ROI analysis ignores the time value of money. Therefore, it should not be used for long-term projects or should be combined with NPV analysis for better decisions.
What is Economic Value Added?
Economic value added (EVA) is a financial metric that is used to determine the net profitability of a company above its cost of capital.
EVA takes simple profitability metrics to the next stage. It considers a company profitable only when it is generating sufficient returns for its shareholders.
EVA is also referred to as the economic profit of a company as it reflects the economic profitability. In that sense, it also reveals the performance of the management of the company.
EVA is a useful financial and performance measurement metric used by shareholders and investors. It appraises the economic profit by using the WACC of the company.
How to Calculate EVA?
EVA can be calculated by using the following formula:
EVA = NOPAT – (Invested Capital × WACC)
Let us elaborate on the three main components of the EVA formula.
It is the net operating profit after tax of the company. It can be calculated manually by starting with the operating profit and making adjustments.
It should be adjusted for the tax charge since we are analyzing the economic profit for shareholders here.
It includes all types of capital like debts, short-term loans, and equity investments.
This figure can also be taken from the balance sheet of the company.
The weighted average cost of the company can be calculated by using the formula:
WACC = Ke × E/ (E+D) + Kd (1 -t) × D/ (E+D)
Finally, we can input these three components into the EVA formula to calculate the result.
Importance and Uses of EVA
It is an alternative profitability measure that calculates the economic profit of a company. It considers a company profitable when it generates returns above the cost of capital for its shareholders.
Simply, it tells us how well a company is utilizing its invested capital. In other words, what is the company generating for its shareholders after paying all expenses?
EVA can be used for investment and project appraisals as well. It quantifies the invested capital and uses the WACC to appraise the investment returns.
One of the advantages of EVA is that it offers an incentive to all stakeholders of a company to perform well. Shareholders can use it for performance appraisal of managers as well.
NPV Vs ROI Vs EVA – Key Differences
Let us summarize the key difference between NPV, ROI, and EVA here.
- NPV is widely used for investment appraisals, financial securities, and comparison purposes.
- ROI is a simple investment appraisal method without considering the discounting factor.
- EVA calculates the economic profit of a business above invested capital discounted at the WACC of the company.
- NPV considers the time value of the money. It uses WACC which is calculated by the company for other appraisals as well. It can be used for cash flow forecasts, investment appraisals, and other performance evaluation processes.
- ROI is a simple profitability measure that does not account for the discounting factor. It is widely used by managers for its simplicity and profitability and investment appraisals.
- EVA is an alternative approach to conventional profitability metrics. It evaluates the profitability of a business for shareholders beyond and above the invested capital. It also considers the discount factor (WACC) to include the time value of money concept.
- NPV is a widely used metric. It considers the time value of money. It focuses on cash flows rather than profitability. It can be used for appraisals and comparisons.
- ROI is simple and easy to calculate. It is described in percentage terms and can be used for trend analysis as well as comparisons.
- EVA is a useful metric for shareholders. It shows the economic wealth generated by the company for its shareholders. It considers the invested capital, discount factor for the time value of money, and operating profit.
- NPV is subject to manipulation and errors. WACC can be adjusted to show favorable results. It focuses on cash flows rather than the profitability of the business.
- ROI ignores the time value of the money. It also requires adjustments for annualized returns to compare similar investment options.
- EVA relies on three different components. If the invested capital changes, the EVA will change and does not reveal the performance of the company objectively. Also, EVA is subject to manipulation with accounting adjustments for operating profit and WACC calculations.