Net Present Value Analysis: A Primer for Finance Officers.

• Author: Michel, R. Gregory

This article demonstrates how to use a decision tool called net present value (NPV) analysis to evaluate a project's long-term financial costs and benefits.

A traditional analysis of a project's long-term costs and benefits simply adds together each year's cost or benefit so that the total cost is the sum of the costs in each year, and the total benefit is the sum of the benefits in each year. Subtracting the total cost from the total benefit calculates a project's total net benefit.

The flaw of the traditional method of analysis is that it assumes that dollars in future years have the same value as dollars today and can simply be added together. Although a traditional analysis gives dollars in the future the same value as dollars today, governments, and society as a whole, implicitly place a lower value on future dollars than current dollars, a concept known as the time value of money. One simple example that proves this is a savings bond. A $100 savings bond that matures in 10 years represents $100 in the future, however, it is worth much less than a $100 bill today.

Governments also place a higher value on dollars today rather than dollars in the future. Many governments are willing to pay an interest cost to borrow money to finance capital projects. Instead of paying an interest cost to borrow money, a government could have saved money year by year to meet future capital needs. The fact that a government chose to spend its revenue on current rather than future needs (and pay an interest cost down the road) proves that it places a higher value on current rather than future needs.

Since traditional analysis gives a mistakenly high value to dollars in the future, it may provide poor information. In traditional analysis of capital projects, money in the future is given the same value as money today; but as proven above, money in the future is given a lower value than money today. Thus, traditional analysis may provide an estimate that is inconsistent with a decision-maker's criteria. Net present value analysis closely matches the criteria that governments implicitly use when making long-term decisions--meaning that it gives a lower value to dollars in the future.

Instead of simply adding together each year's cost or benefit, net present value analysis first converts the value of future costs and benefits to their actual value today. This is like converting the value that is written on the face of a savings bond to its actual value today. After converting each year's future value to a present value, the net benefits for each year are summed to calculate the total net benefit.

To convert future dollars to present dollars, net present value analysis uses a number called a "discount rate." A discount rate reflects a government's cost of borrowing or a community's preference for present versus future consumption. Although there is no standard government discount rate, the interest rates in the nation's financial markets are a good source for determining a discount rate.

How to Do a NPV Analysis

Net present value analysis involves four basic steps.

* The first step is to forecast the benefits and costs in each year.

* The second step is to determine a discount rate.

* The third step is to use a formula to calculate the net present value.

* The final step is to compare the net present values of the alternatives.

Step 1: For each alternative, forecast the benefits and costs in each year. To begin, forecast the total benefits and total costs in each year. A typical forecast of costs and benefits might look something like Exhibit 1. In this example, the government would incur large upfront costs but enjoy a stream of benefits in later years.

Making accurate forecasts of future costs and benefits can be the most difficult step in net present value analysis. Analysts should follow five general rules when forecasting costs and benefits.

1) Forecast benefits and costs in today's dollars.

2) Do not include sunk costs.

3) Include opportunity costs.

4) Use expected value to estimate uncertain benefits and costs.

5) Omit non-monetary costs and benefits.

Forecast benefits and costs in today's dollars. It is important to treat inflation consistently throughout a net present value calculation, so all forecasts of future costs and benefits should be made in today's dollars, i.e., real dollars, and discounted at a real discount rate. [1] When a forecast is made in "real" dollars, future costs and benefits are not increased to include the effect of inflation. In other words, if a benefit of $100,000 is forecast for the fifth year of a project, that $100,000 will have the same buying power as $100,000 today.

As an alternative to making forecasts in real dollars, it is also possible to make all forecasts in nominal dollars and discount them at a nominal discount rate. However, forecasts in real dollars are easier to make and understand than forecasts in nominal...