Net present value method — decision support for investments
What is the net present value method? - The definition
Die Net present value method, also Net Present Value (NPV) method called, is an instrument of dynamic investment appraisal and enables investors to calculate the financial value of an investment. The aim of this method is to discount the value of future cash flows to the present time and to decide whether an investment — such as in real estate, securities or machinery — is profitable. A positive net present value shows that the investment is worthwhile, as the return exceeds the initial investment amount and the fixed interest rate.
How is the net present value calculated?
The calculation of the net present value is based on discounting all future cash flows, such as deposits and withdrawals. The following factors are required for this:
- Investment amount: The costs of the investment.
- Deposits and withdrawals: Cash flows that are expected from the investment.
- Capitalization rate: This interest rate, also known as a discount interest rate, meets the return expectations of an alternative investment.
The calculation formula is:
Net present value = present value of disbursements — investment amount
example: Ms. Müller plans to invest 100,000 CHF in condominium property in Zurich, which she would like to sell after two years for 110,000 CHF. If your bank offers an interest rate of 4% for alternative investments, it uses this as a calculation interest rate.
The calculation results in:
- Present value of payments = 110,000 CHF/(1 + 0.04) ^2 = 101,701 CHF
- Net present value = 101,701 CHF — 100,000 CHF = 1,701 CHF
The positive result of 1,701 CHF shows that the investment is worthwhile.
Tip: Read our article on real estate gains tax!
Scenario change: If the calculation interest rate were to rise to 5%, the present value would fall to 99,773 CHF, resulting in a negative net present value of -227 CHF. In this case, the investment is not worthwhile as it lags behind the alternative investment.
Interpretation of net present value results
The net present value method provides investors with three possible scenarios:
- Net present value is positive: The investment exceeds the target interest rate and the measure is profitable.
- Net present value is zero: The return is exactly in line with the target interest rate. Further consideration is needed.
- Net present value is negative: The investment does not meet the return requirement and is therefore less attractive than alternatives.
The influence of the capitalization rate is important here, as even small fluctuations can change the interpretation of results. This is particularly relevant because assumptions must often be made that may not exactly correspond to reality.
Net Present Value Method: Advantages and Disadvantages
The net present value method is popular because it:
- Simple basis for decision-making offers: The net present value shows directly whether an investment makes economic sense.
- temporal values taken into account: Future cash flows are comparable as a result of discounting.
However, it also has limitations:
- Unrealistic assumptions: The method requires equal debit and credit interest and neglects tax aspects.
- Dependence on calculation interest: Varying interest rates can lead to incorrect results.
In summary, the net present value method is a useful tool for Assessment of profitability, but it is recommended to use other indicators to help.
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