Answers questions: 1, 2, 3, 4, 5, and 7. MUST BE DONE IN EXCEL
Explanation and Example of NPV
You will notice that this case study requires the use of a function called “NPV”. The NPV, Net Present Value, as the name suggests, gives you the present value netting out all inflows and outflows; that is, it is the PV of all costs and benefits throughout the life of a project. Typically, but not always, projects have an initial outflow (cost or investment) and subsequent benefits (inflows or benefits). But the NPV is powerful enough to handle any combinations of costs and benefits throughout the life of the project/investment.
Take the case of the new airport currently being built in Kenner. We can estimate its Net Present Value if we know how much it is costing to build and what are the expected benefits. Let’s say it costs $200 million to build and that it will generate $25 million in tourism benefits per year for the next 20 years -notice the benefits (payments) are constant. You know now that you cannot just say that $25×20=$500 million is the aggregate benefit of building the new airport. Instead, using the TVM knowledge, we can estimate that, at a 5% rate, the present value of the constant payment structure is =PV(5%,20,25)=$311.56 million. If we now subtract the initial cost of 200 million (which now is in the same period of time as the PV=$311.56 and we can, therefore, compare/add/subtract) we obtain a Net Benefit of $111.56 million; this is the Net Present Value. This can be done directly in Excel with the NPV function like this:
Notice that this was initially done by simply using the TVM concepts of PV and Payments. But, there are instances in which the benefits may not be constant. When this is the case, the TVM functions will no longer work because the TVM requires constant payments through time. But the NPV function works regardless of which cash-flows are given. Let’s change the benefits of the airport to 5 years of $5 million followed by 15 years of $20 million, making the benefit structure non-constant for the 20 year period. The NPV will now be:
In this version, the NPV of this construction will be $-15.70 which means that the expected benefits will not even cover the $200 million investment cost. And if this was indeed the case, the investment should be avoided. This brings us to a cardinal rule of capital budgeting (basically our name for how to use our cash resources): One should only invest in Positive Net Present Value Projects.