Understand the Net Present Value & Cost Of Capital

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alexnkc
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Hi,

I am try to understand the Net Present Value and I found clueless to flow.

My understanding of the Cost Of Capital was the cost that needed to raise the Capital (return of the earning money to people who provide the capital). While Net Present Value was the future earning that "convert" to today day's value.

Table below was the summary from the text book question's answer

* Cost of Capital / Discounted Factor = 12%
Year | Investment | Net Cash Flow | Cost Of Capital | Present Value
Year 0 | (4,000,000) |(4,000,000) | 1.000 | (4,000,000)
Year 1 | | 2,080,000 | 0.893 | 1,857,440
Year 2 | | 2,180,000 | 0.797 | 1,737,460
Year 3 | | 2,280,000 | 0.712 | 1,623,360

NPV | | | | (1,218,260)


Question
1. After 3 years, the business was having NPV of negative value. Mean the business was not making money. Am I Right?

2. What is the meaning of the Present Value from each respective year? Did it mean that the cash flow that generated for respective year and "converted" to present year's value? (mean that the cash generated was getting lesser and lesser)?

Thanks
KC
(Newbie in Finance and Accounting Field)
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Delirium.
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I'll try to keep this simple, Think of it this way:

The longer you have to wait for a cash flow the more risk you have that it won't happen (maybe customers don't pay or market conditions change) and the more interest you have lost (as if you had the cash in the bank you could earn interest on it).

With this in mind cash that you expect sooner is worth more than cash you expect later, as less risk and less lost interest. This is called the time value of money.

Discounting expected future cash flows is a way of attaching more value to cash you expect to receive sooner and less value to cash you receive later.

In your example your investment before discounting was a £4m cash outflow, followed by £6m cash inflow over three years. In cash terms we would be up £2m.

However, as the cash outflow happens immediately it's certain and isn't discounted. But as the cash inflows happen in the future (exposed to risk that we won't get them and the loss of interest) they are discounted. The discount rate used in the example was 12% and at that rate the net present value is negative, suggesting that you should not proceed with the investment as value is likely to be lost (I.e. Don't spend £4m to get £2m a year for three years as you are likely to end up with less money than if the £4m was sat in a risk free investment earning guaranteed interest for the period).
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alexnkc
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Thanks Delirium. Now I get it. Thanks for your explanation. :-)

(Original post by Delirium.)
I'll try to keep this simple, Think of it this way:

The longer you have to wait for a cash flow the more risk you have that it won't happen (maybe customers don't pay or market conditions change) and the more interest you have lost (as if you had the cash in the bank you could earn interest on it).

With this in mind cash that you expect sooner is worth more than cash you expect later, as less risk and less lost interest. This is called the time value of money.

Discounting expected future cash flows is a way of attaching more value to cash you expect to receive sooner and less value to cash you receive later.

In your example your investment before discounting was a £4m cash outflow, followed by £6m cash inflow over three years. In cash terms we would be up £2m.

However, as the cash outflow happens immediately it's certain and isn't discounted. But as the cash inflows happen in the future (exposed to risk that we won't get them and the loss of interest) they are discounted. The discount rate used in the example was 12% and at that rate the net present value is negative, suggesting that you should not proceed with the investment as value is likely to be lost (I.e. Don't spend £4m to get £2m a year for three years as you are likely to end up with less money than if the £4m was sat in a risk free investment earning guaranteed interest for the period).
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