The manual solution has a simple structure: we just have to pay out the required wages every year. If we decide to buy the machine, then we have to pay the purchase price now (this is also known as the first cost) and also pay a small maintenance fee each year. For the sake of the argument, assume also that we expect to use the machine for ten years and then sell it on for scrap value.
In economics texts, you will often find the sequence of payments visualized using cash-flow diagrams (see Figure 17-1). Time progresses from left to right; inflows are indicated by upward-pointing arrows and outflows by downward-pointing arrows.
To decide between different alternatives, we now proceed as follows:
- Determine all individual net cash flows (net cash flows, because we offset annual costs against revenues).
- Discount each cash flow to its present value.
- Add up all contributions.
The quantity obtained in the last step is known either as the net present value (NPV) or the discounted net cash flow: it is the total value of all cash flows, each properly discounted to its present value. In other words, our financial situation will be the same, whether we execute the entire series of cash flows or receive the net present value today. Because the net present value contains all inflows and outflows (properly discounted to the present value), it is a comprehensive single measure that can be used to compare the financial outcomes of different investment strategies.
We can express the net present value of a series of cash flows in a single formula:
where c(i) is the net cash flow at payment period i and 1/(1 + p/100)i is the associated discounting factor.
There is one more concept that is interesting in this context. What should we use for the discount rate p in the second step above? Instead of supplying a value, we can ask how much interest we would have to receive elsewhere (on a “safe” investment) to obtain the same (or higher) payoff than that expected from the planned project. Let’s consider an example. Assume we are evaluating a project that would require us to purchase some piece of equipment at the beginning but that would then result in a series of positive cash flows over the next so many years. Is this a “good” investment? It is if its net present value is positive! (That’s pretty much the definition of “net present value”: the NPV takes into account the first cost to purchase the equipment as well as the subsequent positive cash flows. If the discounted cash flows are greater than the first cost, we come out ahead.) But the net present value depends on the discount rate p, so we need to find that value of p for which the NPV first becomes zero: if we can earn a higher interest rate elsewhere, then the project does not make financial sense and we should instead take our money to the bank. But if the bank would pay us less than the rate of return just calculated, then the project is financially the better option. (To find a numeric value for the rate of return, plug your cash flow structure c(i) into the equation for NPV and then solve for p. Unless the cash flows are particularly simple, you will have to do this numerically.)
The net present value is such an important criterion when making investment decisions because it provides us with a single number that summarizes the financial results of any planned project. It gives us an objective (financial) quantity to decide among different investment alternatives.
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