Discount Rates in Net Present Value

What is Net Present Value?

Net Present Value (NPV) represents the difference between the present value of cash flows and the present value of cash outflows for a project or investment. NPV is a common technique used in capital budgeting and investment planning. Entities use NPV to determine whether a project or investment is profitable and will result in an increase in wealth.

Calculating the NPV of a project or investment requires entities to calculate the present values of all cash inflows and outflows and compare them. If the difference between them is positive, meaning the cash inflows exceed the cash outflows, the project is considered feasible. In contrast, if the NPV is negative, the project is loss-making.

For entities, calculating the NPV of a project or investment requires using a discount rate. Based on this rate, entities can calculate the present values of their cash flows. This rate is not constant for all entities and depends on several factors. Therefore, it is crucial to look at what discount rates in NPVs means.

What are Discount Rates in NPV?

Discount rates in NPV and finance represent the rate of return that entities use to discount future cash flows to their present value. For companies, the discount rate is often the Weighted Average Cost of Capital (WACC). For other entities, it may be the required rate of return or hurdle rate.

Companies use the WACC as a discount rate because it includes their cost of equity and debt. For projects financed through equity or debt only, companies can use the cost of equity or cost of debt as the discount rate. For internal corporate projects, companies may also use a predefined hurdle rate. Some entities may also use the risk-free rate as a discount rate.

Through the discount rate, entities decide the rate at which they want to recover their investments. Higher discount rates will result in lower NPVs, while lower discount rates will return higher NPVs. Discount rates in NPV are, therefore, crucial in determining a project's overall profitability. Similarly, entities must decide on the right discount rate to get accurate results for their projects or investments.

Example

A company, Blue Co., wants to finance a project. The initial investment required for the project is $100,000. Blue Co. expects the following cash flows from the project.

Year	Cash Inflows ($)
1	35,000
2	30,000
3	25,000
4	25,000
5	20,000
Total	130,000

The company determines its Weighted Average Cost of Capital to be 10%. It is the rate that Blue Co. will use to determine the present value of the above cash inflows. Therefore, the project's NPV based on the 10% discount rate will be as follows.

Year	Cash Inflows ($)	Discount Factor (10%)	Discounted Cash Inflows
1	35,000	0.909	31,815
2	30,000	0.826	24,780
3	25,000	0.751	18,775
4	25,000	0.683	17,075
5	20,000	0.621	12,420
Total	135,000		104,865

NPV = Present Value of Cash Inflows - Present Value of Cash Outflows

NPV = $104,865 - $100,000

NPV = $4,865

Therefore, a discount rate of 10% will result in a positive NPV for the project. According to the rules of NPV, the project is feasible and profit-making. Blue Co. can choose to take the project based on the 10% discount rate in NPV.

Conclusion

Net Present Value is a common technique used in capital budgeting. It represents the difference between a project's present value of cash inflows and the present value of cash outflows. Calculating these present values requires entities to determine a discount rate to use in NPV. The discount rate can be crucial in the outcome of the technique.

Originally Published Here: Discount Rates in Net Present Value