Often managers are asked to have an NPV (or DCF) calculation done on projects they are proposing. This NPV calculation will typically be performed by the Finance team. But what are they actually doing?
If I asked you to give me £100 now and I told you that I would give you back £100 in one year, would you do it?
I would hope you answered ‘no’ to this as there is no advantage to you in the deal. You understand that you would be better keeping the £100 and investing it in a bank account where you might get some interest.
What if I said that if you gave me the £100 now I will give you £110 in a year?
Now you might be interested. It would depend on how much money you could earn yourself by investing the £100 compared to the £110 I will give you. If you could earn more that £10 you won’t give me the money, if you couldn’t you would give me it.
If we take this into the business world and you were doing a project that required the business to invest £100k as a result of which the business was going to get cost savings in year one of £50k and savings in year 2 of £70k, is this worthwhile for the business.
It depends again on how well the business could use this £100k elsewhere on other projects. The accountant will use the NPV technique to determine whether the project is worthwhile for the business.
If you want to know more about how the NPV process works we can provide in house courses focused on how your business assesses its projects.