In the Present Value economic model for project selection, you calculate the present value of a future cash flow from the project. You do not deduct anything from the value you have calculated. However, when calculating a Net Present Value (NPV), you deduct the costs incurred on the project from the present value of the project.
When calculating the net present value of the project, you first calculate the present value of the project revenue as well as the project cost over many periods of time. After calculating the present value of the project revenue and the project cost, you deduct the present value of the project cost form the present value of the project revenue to get the net present value of the project. If the resultant net present value is positive, it would be fruitful to select the project. Else, it would result in a loss making proposition.
You calculate the cost incurred on a project over multiple time periods the same way as you do for the present value for the project revenue. The only difference is that while calculating present value for the revenue, the value is always lower than the actual value because you lose on the interest that you would have otherwise accrued. However, in case of present value of the cost, the effective cost is lesser because you have already earned an interest on the amount.
Consider the following example. In a project you have to invest an initial amount of $ 6,000 and another $ 3,000 each in the first and second years. The projects is expected to generate revenue of $ 500 in the second year, $ 1,000 in the third year, $ 5,000 in the fourth year, and $ 10,000 in fifth year. Now, calculate the net present value of the project and evaluate if it is worth considering going ahead with the project.
To calculate the net present value of the project, you must calculate the present value of the cost as well as revenue by using the present value formula and then add the respective values. In this example, consider the prevailing rate of interest as 10% per annum. You can use a table similar to the following to make the calculations:
|Time Period||Revenue||Calculate PV of Revenue||Present Value of Revenue||Cost||Calculate PV of Cost||Present Value of Cost|
Net Present Value = 10,788 – 11,206 = -418
Notice that the total revenue generated from the project is $ 16,500. As a project manager, you might not want to consider this project because the net present value of the project is negative (-418). You always consider a project that has a positive net present value.
You can calculate net present values for all projects under consideration and select the one with highest and positive net present value.