The importance of net present value for project managers
Blog: Monday Project Management Blog
Calculating net present value (NPV) offers an instantaneous picture of the internal rate of return you can expect from a potential investment.
Most commonly used for cost reduction, new venture launches, capital investments, and business valuation, NPV is an important capital budgeting tool that can also provide valuable insight for project managers.
What is net present value?
NPV describes the total amount of money you can expect an investment to generate over its lifetime, including both positive and negative future cash flows. When calculating NPV, we adjust the projected income and expenses to reflect the present value of cash. Cash you have in hand right now is worth more than money you might have in the future. Future cash misses out on the ability to take advantage of accumulating interest rates beginning right now, and it has less purchasing power because of inflation.
When NPV is positive, the project or investment will provide a return on your initial investment. Negative NPV reflects that cash inflows will be lower than the outflows over the course of the project. NPV of zero indicates that the financial income and output required for a project will balance one another nearly evenly over the specified time periods.
For the purposes of calculating NPV, the initial investment is the amount you pay up front for an opportunity or the total up-front expenses of a new project. Future cash flow describes both the ongoing expenses (broker fees for an investment, for example) and returns of the project. The discount rate, or the rate used to adjust future cash flow for current economic conditions, may also be called the interest rate when analyzing NPV. The time period for NPV applies if you have a set time limit to receive the returns. For example, if the project is a limited edition line of merchandise, the time period in question could be just a few months.
Comparing net present value to other management metrics
While NPV serves as the go-to project management metric from a financial standpoint, it’s important to understand that it relies on assumptions that may not reflect a true projection of risk. For the most precision, you’ll need to account for external factors that can impact the outcome of a project or investment.
NPV also assumes the discount rate remains the same over time, while in actuality the change in value varies based on economic conditions, inflation, and related factors. Usually, the chief financial officer sets the discount rate for a specific project or investment. Common benchmarks include the company’s cost of borrowing money or the amount shareholders expect to earn from an endeavor. You can also use the cost of capital necessary for the project as the discount rate.
Despite these flaws, however, NPV provides more useful information than related management metrics. In fact, Harvard Business Review reports that positive NPV usually correlates with a strong investment return, while negative NPV accurately identifies a failed investment in most cases. Double-checking your estimates and assumptions can improve your data.
Unlike other relevant metrics, NPV automatically accounts for long-term risk, another confidence-building attribute. Even if you’re not a statistician, you can easily explain this metric and how it affects project management across your organization.
For example, the payback method offers a simple way to figure out the return on investment, but it’s not as accurate as NPV since it doesn’t account for the fact that $1 is worth more today than $1 will be worth in the future. As a result, it could overstate the potential return your team can expect.
Internal rate of return (IRR) is another common metric used instead of or in conjunction with NPV. IRR uses trial and error to adjust the discount rate throughout the project period, while NPV has a static discount rate. However, because IRR doesn’t consider market rates, it isn’t as reliable as NPV.
Net present value in project management
Executives often use NPV to decide which projects they want to pursue, along with payback method and internal rate of return. Most financial analysts rely on NPV in this situation to create a benchmark the team can compare across projects to decide which will be most profitable for the company to pursue.
Simply put, you can determine whether the allocated budget makes sense given the likely cash returns in today’s money. Otherwise, you’d be comparing the less valuable future funds to the value of a current investment, which provides an imprecise view of whether an endeavor will be worthwhile.
Net present value has a long history in the project management field. Project Management Quarterly published research in 1981 illustrating the use of this metric in project scheduling. The study authors noted that NPV is a particularly effective project management tool in sectors such as communications in which a campaign could cost several million dollars or more. Since it could take up to five years or longer to realize returns on large-scale projects, NPV can help teams time cash flow to support organizational sustainability.
When should you use net present value?
Some of the most valuable uses of NPV include:
- Determining the future value of a start-up as you prepare to seek investors by building a discounted cash flow (DCF) model
- Forecasting the cash inflows and outflows over the life of a project
- Deciding whether to make significant purchases such as real estate, equipment, or software
- Guiding budget allocation for a capital investment
- Analyzing whether purchasing or merging with another company would be a good investment
Track your net present value with monday.com
monday.com makes it easy to track the cost-benefit of your projects with templates to calculate metrics such as net present value. Start with the Project Cost Management Template to run a cost-benefit analysis and access other important project management functions on one customized workflow. You can also use this template to keep track of key stakeholders, establish a project schedule with deadlines and milestones, monitor progress towards objectives, and assess the organizational impact of your initiative — including its NPV. Our tools streamline high-level analysis by integrating with your favorite apps, and you can always reach out to our customer service experts if you get stuck.
Frequently asked questions
How do you calculate the net present value?
The formula to calculate NPV is the sum of [Total cash flow for the year/(1+Discount Rate)n] where n is equal to the number of years. However, you can also use Excel and other financial software to perform the NPV calculation automatically.
What does net present value show?
Net present value shows how much money a project or investment will gain or lose in terms of today’s funds. Future cash flow doesn’t closely reflect current cash flow of a project because of the impact of factors such as inflation and lost compound interest, so NPV adjusts accordingly.
Why is net present value important?
Knowing net present value allows project managers to accurately predict the return on their initial investment, which can inform whether it makes sense to move forward with a particular initiative. It also converts this predicted return to today’s dollars, so you can make immediate financial decisions for your company with elevated confidence.
Net present value: A powerful predictive tool for project managers
NPV offers valuable insights into the future value of your projects in the context of your organization’s current financial situation. Adding this calculation to your toolkit expands your ability to assess the return on initial investment and make smart assessments accordingly.
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