NPV Reloaded

Surprisingly, my blog post NPV explained in simple words has been the most viewed page on my blog, so far. Wow! I have just resumed my MBA studies at the OUBS (will write more about that soon), with the Financial Strategy course, which takes a lot of these appraisal techniques to the next level.  So I thought maybe you’d like to hear a few more thoughts on NPV and how this can be applied in your business lives, too.

To recap, Net Present Value (NPV) is a financial appraisal technique which discounts all expected cash flows of an investment (e.g. a project with all related costs such as development, rollout, maintenance,…) to today’s value of money. If you get an NPV of zero, this means you will be able to get the expected level of return (the one which you used to discount your cash flows) and could go ahead with the investment. Of course, the larger the positive sum of the NPV, the better. From a pure financial perspective, you should reconsider investments with a negative NPV. So far, so good.

There are several limitations of this model. One of it is that you are only considering one scenario (usually, the most likely one). As all of the cash flows are futuristic, and a bigger portion of them usually uncertain (like expected cash inflows from sold products or actual maintenance costs occurring), the NPV concept has been expanded to ‘Expected NPV’.

The idea is very simple but quite powerful as it allows you to better take the real world and potential scenarios into account:

1. Decide on a range of scenarios you’d like to cover.
   Typically, in a project context this would be something like ‘Best Case’, ‘Most likely’, and ‘Worst case’.
2. Assign probabilities to the identified scenarios. Make sure all the probabilities add up to 100% ;)
   For example:

   Best case:   20%
   Most likely: 60%
   Worst case:  20%

3. Calculate the NPV for each of the scenarios.
4. Calculate the arithmetic mean NPV, which is simpler than it sounds: Just multiply each individual scenario’s NPV with its probability and add it all up:

   Best Case:   NPV = 10.000EUR * 0.20 =  2.000EUR
   Most likely: NPV =  5.000EUR * 0.60 =  3.000EUR
   Worst Case:  NPV = -1.000EUR * 0.20 = -  200EUR
   -----------------------------------------------
                Resulting Expected NPV =  4.800EUR
   ===============================================

Aside from getting a EUR/USD/GBP amount out of it, the process alone will help you getting a better feeling for your project. Have a look at the scenarios – how widely are they spread, how symmetrical are they w/ regards to their probability and outcome? Any extreme values? As always, calculate and interpret in brain-on mode!

Usually, NPV will be used in the early stages of the project and should be part of the business case brought forward. In the Prince2 world, it should be completed by the end of the ‘Initiate a project’ stage where the Business Case is verified and baselined.

How common is NPV in the project appraisal and authorization processes in your organization? Please participate in the poll below.