Net Present Value defined

Net Present Value is a big part of your ROI process, but you need the formula first.

Net Present Value: The sum that results when the discounted value of the expected costs of an investment are deducted from the discounted value of the expected returns.

The Net Present Value (NPV) benefit measures the net benefit of a project in today's dollar terms. The NPV savings calculation consists of two financial concepts that evaluate a set of costs and benefits over time:

  • The "net" is the difference between all costs and all benefits (savings and other gains).
  • The present value takes into account the time value of money; this adjusts to expenditures and returns, as they occur over time, so they can be evaluated equally.

Money has a time value, known as an opportunity cost, which means that money invested today could earn interest elsewhere. To compensate, future payments need to be higher so that they equal today's dollars. Additionally, time value accounts for the cost of capital, investment money that costs the company to borrow over time at a specific interest rate. The cash flows are the amounts and times of the various costs and investments, and these are brought into a common term, today's dollars, so that the net benefit can be evaluated.


Figure 1: Typical net present value graph

Let's say a company invests $100,000 in a new application, and it requires $25,000 annually thereafter in maintenance and support costs. From this investment, the company expects to save $200,000 each year. An analysis of this investment over three years would yield the following negative (costs) and positive (benefit) cash flows:

 

Initial

Year 1

Year 2

Year 3

Cumulative Total

Total Costs

 $      100,000

 $      25,000

 $     25,000

 $     25,000

 $       175,000

Total Benefits

 $              -  

 $     200,000

 $   200,000

 $   200,000

 $       600,000

Net Benefits

 $     (100,000)

 $     175,000 

 $   175,000 

 $   175,000 

 $       425,000 

The cash flow from this investment is shown as the net benefit, which is the total benefits minus total costs: a cash flow of -$100,000 initially (year 0), with $175,000 in year 1, year 2 and year 3.

The NPV savings calculation seems intimidating when expressed as a formula; however, when demonstrated in practical terms it is quite intuitive. To express the NPV calculation in its most difficult terms, use the formula:

Each "I" represents the net benefits for each year; the subscript "0" represents the initial net benefit, the subscript "1" represents the year one net benefit, and so on. The exponent in the denominator is also equal to each year of the analysis, up to "n," the number of years in the analysis term. The discount rate is "r" and is held constant through the analysis period.

To put the calculation in practical, step-by-step terms, we will use the calculation applied against our example cash flows. The net present value calculation, using a cost of capital/discount rate of 7%, takes the initial costs and ongoing costs and benefit cash flows to create a single net cost or savings figure. For the example above, the net benefits are as follows:

Initial        =    I0       =    - $100,000

Year 1      =    I1       =    + $175,000

Year 2      =    I2       =    + $175,000

Year 3      =    I3       =    + $175,000

The initial expense of $100,000 is not discounted because it is already in today's dollars terms. However, years one through three need to be adjusted to be brought into today's dollar terms and are calculated as follows:

NPV Year 1 = $175,000 / (1+ .07) = $163,551

NPV Year 2 = $175,000 / (1+.07)2 = $152,852

NPV Year 3 = $175,000 / (1+.07)3 = $142,852

The total NPV savings is the sum of the initial expense and the three-year NPV analysis, represented as:

NPV Savings = - $100,000 + $163,551+ $152,852 + $142,852 = $359,255

As shown, the net benefits from later years are discounted more in today's dollar terms such that they mean less in the overall analysis. As a result, the total NPV savings is only $359,255 compared to the cumulative benefits of $425,000 when the discount rate is not considered. Because the net present value calculation increases the impact of current costs and near term savings while reducing the impact of future costs or benefits, the following holds true:

  • Projects with high initial costs and savings that grow slowly over time yield lower NPV savings values.
  • Projects with low initial costs and greater initial savings yield higher NPV savings calculations.

The NPV Savings is one of the most popular and accurate methods used to assess IT project viability. NPV is different from ROI, which is a ratio of net benefits to the costs, because NPV savings uses discounted cash flow to quantify, in today's dollar terms, the projected net gain from the project in net dollar terms.

However, like the ROI formula, it alone cannot determine whether a project is viable. As an example, a project may yield a substantial $100 million NPV savings over a three-year period, but the required initial investment of $10 million may be too risky for the company. Also, a project might have a large NPV benefit but has a long payback period and derives much of its benefits through huge gains in outgoing years. Therefore, the NPV savings metric should be used in conjunction with other metrics such as ROI, IRR and payback period to paint a clear investment picture.

Tom Pisello is the CEO of Orlando-based Alinean, the ROI consultancy helping CIOs, consultants and vendors assess and articulate the business value of IT investments. He can be reached at tpisello@alinean.com.

This was first published in July 2005

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