0

I recently viewed a Youtube on Net Present Value (NPV), to gain a better understanding of the concept. Towards the end of the video the uploader makes the claim that the project has added value to the firm, above and beyond the 6% that they could have invested elsewhere.

But that doesn't make sense. If you could have invested the original 10,000 elsewhere at 6% per year you would get 10,000 ( 1 +.06)^5 = $13382.26 for a profit of $3328.26. This is greater than the calculated NPV of $3239 for the project.

I am also confused about how the discount rate is calculated. It seems that once you find a discount rate, it is always better to invest the money elsewhere than to undertake a given project whose cash flow you are discounting. For example in the problem above it makes more sense to invest the money elsewhere at 6% than to invest it in the project.

  • You should include the relevant numbers in your question, rather than asking people to watch a video. What discount rate do they use? What's the nominal profit? Etc. – Acccumulation May 8 '18 at 22:00
1

Your calculation of the 10,000 * (1+0.06)^5 = 13,382.26 does not take into account the time value of money. You wouldn't get that entire profit of $3328.26 today, you get it five years from now. Meaning you need to discount it by (1.06)^5 in the denominator to get the NPV.

[10,000 * (1.06)^5] / (1.06)^5 = exactly 10,000. -10,000 in year 1 + 10,000 in year 5 = exactly 0.

So the correct comparison here is $3239 > 0, not $3328.26.

  • Thanks for the reply. What does NPV = 0 indicate. Is that what happens if you chose not to do the project and just invest it in a 6% investment , like a 6% cd that you cash in after 5 years? Though 6% seems pretty high. – john Apr 9 '18 at 3:18
  • Correct. Every year the 6% interest you gain is exactly canceled out by the 6% discount rate, so you're neither better nor worse off. – SlugFrisco Apr 9 '18 at 3:22
  • Also it looks like the rate of return of the project can be calculated another way. If you add the cash-flows 2500 +4000 + 5000 + 3000 + 1000 = 15,500 , this is larger than the 10,000 * (1+0.06)^5 = 13,382.26. And 10000(1 + .092)^5 = 15,500. So the overall rate of return on the project is 9.2% – john Apr 9 '18 at 3:42
  • 1
    Nope. You can't just simplify like that. Every cash flow needs to be discounted based on when it's paid out. – SlugFrisco Apr 9 '18 at 4:49
  • @john the 6% interest rate is very high but that's because it's chosen to make the maths interesting and a little bit easier rather than to be realistic. Its the finance version of Vikram buying 14 apples and 21 oranges in school textbooks. – MD-Tech May 9 '18 at 12:16

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.