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Week 10 Discussion..edited

The net present value (NPV) measures the value of an investment discounted to today. It is used to determine if a project is profitable by comparing the present value of cash inflows to outflows. A positive NPV means the project should be invested in, while a negative NPV means it should be avoided. NPV is more sensitive to changes in cost of capital for long-term projects since there is more time for variables like inflation and interest rates to fluctuate. Two examples are given, one short-term and one long-term, showing the long-term project's NPV was more impacted by a negative cash flow than the short-term project.

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19 views

Week 10 Discussion..edited

The net present value (NPV) measures the value of an investment discounted to today. It is used to determine if a project is profitable by comparing the present value of cash inflows to outflows. A positive NPV means the project should be invested in, while a negative NPV means it should be avoided. NPV is more sensitive to changes in cost of capital for long-term projects since there is more time for variables like inflation and interest rates to fluctuate. Two examples are given, one short-term and one long-term, showing the long-term project's NPV was more impacted by a negative cash flow than the short-term project.

Uploaded by

Joshua Mukoma
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We take content rights seriously. If you suspect this is your content, claim it here.
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The net present value (NPV) measures how much an investment would be worth throughout its

lifetime, discounted to today’s value. It is used by investors to determine whether to invest in a


given project or not by checking the profitability of the project in the long run (1). If the NPV is
positive, it would be advisable to invest in the project but if the NPV is negative, it would be
advisable not to invest in the project (2). NPV is computed by subtracting the present value of
predicted cash outflows from the present value of expected cash inflows discounted at a suitable
rate, such as the cost of capital. As a result of the discounting process, the interest rate is
compounded during the project's duration. Therefore, the long-term project's NPV is more
sensitive to changes in the cost of capital than a short-term project's NPV because there is more
time for change to occur in the long-term project than in the short-term project. Besides, changes
in the discount rate and inflation rates in the future can negatively or positively affect the NPV of
a long-term project investment compared to how they would affect the NPV of a short-term
project investment (2).

To support this argument, let’s consider the following two examples:

Example 1

Consider project A which has an initial investment of $40000 at a discounted rate of 12% and in
two years it produces the following cash flows: $243000 and $28500. The NPV of the project at
the end of the 2 years is calculated as follows.

NPV = (24300/(1.12))+(28500/(1.12)^2))-40000

= $21696.43 + $22720.03 - $40000

= $4416.46

Since the NPV is positive, we can invest in the project.

Example 2
Consider project B which has an initial investment of $40000 at a discounted rate of 12% and in
five years it produces the following cash flows: $243000, $28500, $15000, -$30500, and $10000.
The NPV of the project at the end of the 2 years is calculated as follows.

NPV = (24300/(1.12))+(28500/(1.12)^2)) + (15000/(1.12)^3) + (-30500/(1.12)^4) +


(10000/(1.12)^5) - 40000
= $21696.43 + $22720.03 + $10676.70 - $19383.30 + $5674.27 - $40000

= $41384.13

Since the NPV is positive, we can invest in the project.

From the two examples shown above, we can note that one of the cash flows in project B was
negative which negatively affected the NPV of the project. The negative value can be due to the
inflation rate or other factors that affected the cash flow during the fourth year. Therefore, we
can say that the NPV of a long-term investment would be more sensitive to changes in the cost of
capital than the short-term NPV investment.

References
1. Gaspars-Wieloch, H., 2019. Project net present value estimation under
uncertainty. Central European Journal of Operations Research, 27(1), pp.179-197.
2. Zamfir, M., Manea, M.D. and Ionescu, L., 2016. Return on investment–indicator for
measuring the profitability of invested capital. Valahian Journal of Economic
Studies, 7(2), pp.79-86.

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