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Net discounted income - the essence on the fingers

Net discounted income - the essence on the fingers

Net discounted income (NPV or NPV)- a simple indicator of the integral evaluation of an investment project. However, some, especially those who decided to understand it for the first time, have certain difficulties in understanding it.

Since NPV is an integral indicator, it means that it is a generalizing indicator by which an objective assessment of the effectiveness of investments is made for the entire duration of the project (from beginning to end), and not for any specific period of its implementation.

Net discounted income, in simple terms, is accumulated (total) the net flow of money that the project generates (receives) during the entire regulatory period of its operation, taking into account its depreciation for each year of its implementation.

And what is a net cash flow?

For each year of project implementation, outflow (investments) is compared with inflow (net income from the implemented project products) and the difference is the net balance of money, which is the net cash flow.

how net cash flow is calculated - picture

The depreciation process is carried out by applying discounting of the net flow for each year, that is, bringing the future value of money to the current one.

Well, for example, today you have lent 1000 rubles to someone and you will be repaid 250 rubles each over the next 4 years.

Will this option suit you ?

We think not. But why?

Because there is, at least, a risk in the depreciation of future money due to inflation. And the money that costs 1000 rubles today, in a year will correspond, for example, to 1100 rubles. with annual inflation of 10%.

Therefore, we can say so, 1000 rubles today = 1100 rubles next year.

the essence of cash flow discounting

Therefore, to bring future money (net cash flow) to the current time period (when planning is carried out), discount factor, which leads the net flow of the project in subsequent years to its current value.

Discount rate= 1 / (1 + Discount rate) t

The discount rate is essentially % inflation + possible risks,

t – the period (0,1,2,3, etc.) relative to which the discount coefficient is calculated.

t at the beginning of the project (first year) is always defined as 0. During this period, the discount rate is equal to 1 (1/(1+10 %)0) . That is, at the time of investment money their real value corresponds to today.  

If you do not take into account other risks of the project (decrease in demand, increase in cost, repairs, etc.), then, at least, the discount rate is based on inflation at the level of the monetary unit (USD, RUB, EUR, BYN) relative to which the NPV is calculated.

For easier perception and understanding, here is a simple example.

Businessman Petya bought a furniture manufacturing plant.

In the first and second year, he plans to purchase and install it (10 000 thousandUSD), and in the third, fourth and subsequent years, until its complete wear (failure), this equipment will begin to bring him an annual net income from the sale of furniture sold (2 300 thousand USD).

If this picture is presented in the form of the dynamics of Petya's project, it will look like this.

example of calculating net discounted income - NPV

The table (without any complicated formulas) clearly shows how the net discounted income for the project is calculated.

It can be seen that the net cash flow is nothing more than the difference between the Inflow (net income - net profit from the sale of products + depreciation) and the outflow of money (investments in the project, equipment, construction and installation work, working capital, etc.) for each year of the implemented the project.

Discounting the net flow for each year gives us a discounted net flow, and its accumulation since the beginning of the project (cumulative) Net discounted income.

It is important for the investor how much he will receive under the conditions laid down in the project (the cost of the project is equipment, smr, working capital;  sales prices, production cost, bank interest rate, % depreciation of money over the years - discounting) of the real accumulated net income as a whole.

This real accumulated net income is nothing else than the Net Discounted Income for the project, and the period where the negative NPV turns into positive corresponds to the discounted payback period.

Therefore, when deciding whether to enter the project or not, Petya will first of all focus on how much he will be able to get net discounted income for the entire duration of the project (until the moment when the equipment is completely worn out and will no longer be able to provide annual net income – this is usually a normative the service life of the project equipment).

The higher the NPV value, the better the project looks economically.

As such, net discounted income does not have a normative value! Its positive value already indicates that the project, in addition to being able to cover the funds invested in it, was also able to earn.

Its value (NPV) plays a role when comparing alternative investment options, in terms of the magnitude of their total return within the entire calculation horizon.

If you need a quick economic assessment of an investment project, with the calculation of all the main integral indicators (net discounted income (NPV), profitability index (PI), internal rate of return (IRR), payback period PP), you can use the following by an online calculator, where the entire order of input of initial data and output of the final result is indicated on a specific example.

Net discounted income - the essence is on your fingers - Something like that!

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