Net present value analysis is a method companies use to review the future profitability of a business project. It is quite common in business and works on a variety of different projects, making it of utmost importance to use correctly. The best tips for using this analysis are to use the same formula to review each project, avoid the inclusion of noncash items in the review, and define the expected goals for each viable project. One issue to remember is that the net present value formula only assesses dollars related to a project. Other considerations may be necessary, such as available resources, space to produce goods, or skilled labor availability.
The basic formula multiples a future dollar amount by a present value factor. Each year the project continues, a different present value factor is used to multiply against the cash flow for that year. The factor is a mathematical formula using an interest rate or cost of capital for computing the factor. It is best to always use the same approach and formula for each project under review at a single time. This allows an apples-to-apples approach that should return values a company can compare to the cost to start and operate each project if selected.
Cash flow is the primary review of any net present value analysis a company uses. Therefore, any noncash item in future years should not have inclusion in the net present value formula. Including these items may lower the initial returns a company compares to the costs to start the project, creating a flawed assessment. Common noncash items found in accounting that can skew net present value analysis include depreciation and amortization. These two costs represent the use of a machine or other item in a production process; while it shows the use of an item for accounting purposes, it serves no purpose in assessing a project’s net present value.
Companies should always define a goal or standard they desire for the net present value analysis. While the most basic goal is that a project’s net present value should be more than the cost to start the project, other goals may be just as worthy. For example, a company may have a predetermined internal rate of return for each project. If a new project fails to meet this goal, it is rejected in favor of another project that may be more profitable or meet stated goals. Goals and standards should be made ahead of conducting net present value analysis.