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Investment Analysis Methodologies - Net Present Value

Sunday, August 07, 2005
We all know, task of a Venture Capitalist is not an easy one. It is not an easy job to calculate the risk in investing in a start-up, but they have to start somewhere. Net Present Value is one such method that is used to analyze the profitability of an investment.

The Net Present Value method (NPV) of evaluating a major investment allows you to consider the time value of money. Essentially, it helps you find the present value in "today's dollars" of the future net cash flow of a project. Then, you can compare that amount with the amount of money needed to implement the project.

If the NPV is greater than the cost, the project will be profitable for you (assuming, of course, that your estimated cash flow is reasonably close to reality). If you have more than one project on the table, you can compute the NPV of both, and choose the one with the greatest difference between NPV and cost. Let us take an example here:

ProjectInitial CostYear 1Year 2Year 3Year 4Year 5Year 6Present ValueNet Present Value
Startup One$10,000$2700$2600$2400$2800$1342$1444$13,286$3286
Startup Two$10,000$2000$2000$2000$500$500$3000$10,000$0
Startup Three$10,000$4000$500$500$500$500$1000$7000-$3000

As an example of how NPV works, let's say you're looking at a project "Startup One" costing $10,000 that is expected to return a total of $13,286 in a period of 6 years. Using NPV analysis you can determine that if the discount rate on the project was 10 percent, the net present value of the expected returns would be $9,967.28. In other words, if you had $9,967.28 today and invested it at 10 percent, after six years you'd wind up with $18,116.67, much more than your return on your project. Thus, it looks as if the expected additional return on the project has shrunk to about $4,830.67, which may not be worth all the time and effort you'd have to put in. Although Startup One seemed to be a profitable proposition as per the table, you just saw it was not very profitable.

NPV analysis is generally used to evaluate the project's cash flows. Although NPV is widely used in Investment decisions, it has disadvantage of not being flexible enough to account for flexibility / uncertainty associated with the project decision.

How do you compute NPV? The easiest way is to use a good financial calculator or Microsoft Excel Spreadsheet's Financial function (NPV). There are online calculators available to perform this calculation.

8/07/2005 08:44:00 PM :: ::


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