One of the core calculations used in capital budgeting is net present value (NPV). Net present value is calculated using the following equation, which says that you add up all the present values of all future cash inflows, and then subtract the sum of the present value of all future cash outflows:
In other words, you take the present value of all future cash flows, both positive and negative, and then add and subtract as appropriate. If the equation looks more complicated than the description, that’s just because of how equations are built. The big “E”-looking symbol is called sigma, and it simply means to add things together — in this case, the present value of future cash flows.
In the case of capital investments, the cash flows come in the form of revenues and costs. Well, that’s true with all cash flows, but these are a little different because they’re operating revenues and costs, rather than financing cash flows, investing cash flows, or even “other” types of cash flows.
In other words, these directly influence the primary operations of the corporation. So the positive cash flows come from the sale of goods and services, as well as the rate of return generated through the reinvestment of the positive cash flows.
If the investment is part of a larger process, you attribute only those revenues that compose an equal proportion of the total value that this particular investment contributed to the final product. The costs of each present value include the financing costs, costs of maintenance and operations, and the interest paid for financing the investment. All cash flows are assumed, of course, to be discounted at the anticipated inflation rate.
Calculate NPV over time
What makes NPV special to capital budgeting isn’t projecting the total value of a potential capital investment; it’s that you can continue to calculate NPV over time. Over the duration of a project’s life, the project’s NPV decreases over time. It has less life and fewer unrealized cash flows because it has already generated revenues in the past.
Performing these calculations allows you to do several things regarding earned value management:
It allows you to determine the value of an investment over the course of its life. That’s great for evaluating corporate value and future operating potential.
It allows you to estimate the market value of an investment at any given point for use as collateral or to determine its liquidation value. Yes, that’s a grim scenario, but it’s really the sort of thing you should be aware of.
It gives vital information about the reinvestment of the net cash flows up until that point.
Manage the project’s value
When you take the NPV of a project at time t (which is any year during the project), you can add the actual returns generated up until that point and more closely manage the project’s value.
Forecasts are always estimates, some more accurate than others, so when the period for a forecast has passed or is in the process of passing, you want to check and see how close you were to the forecast. Then the corporation can adjust its financial outlook accordingly. The net cash flows generated so far are called earned value. Earned value is calculated like this:
All this equation really says is that you take all the present values (PV) you’ve actually completed and add them together. That big thing that looks kind of like a drunk “E” is called a sigma (a capital sigma, not to be confused with a lowercase sigma, which I describe later in the book). It means you add things together. The “start” on the bottom means that you begin with the start of the project. The “current” on top means you end with the current period, without going further. So, you add together cash flows from the beginning until “now” (whenever “now” is), and that’s your earned value. It’s not necessarily what you may expect, though.
Maybe you’re generating higher rates of returns than you expected from your MIRR calculations; in this case, your earned value is higher than your planned value at some point in time. If your earned value is lower than planned, you’re generating lower returns than projected. In either case, it’s probably a good idea to find out what the percentage of difference is and why it occurred. Even if you’re getting higher returns than planned, you want to know why so you can try for a repeat performance. Trust me on this.
Basically, tracking the NPV of a given project allows you to manage the project more effectively, manage finances and resources more efficiently, and better plan for the future. These tasks form the fundamentals of project management, which I discuss briefly at the end of this chapter.