What the Net Present Value (NPV) means
This time Ron is at his wits end. He has sent the accounting team out of his office to rework the numbers. “That simply cannot make sense. If I’m making more than I’m spending, it’s a good decision; right?” He walks into your office for your weekly meeting and asks rhetorically “If I’m spending $2,000,000 today on a new plant and that new plant is going to produce $205,000 for each of the next ten years in income how can that possibly be a negative net decision for the company?”
Can you explain to Ron the concept involved and how that could be a “negative net decision”?
Provide constructive feedback to at least two other students’ postings.
Tips and Tricks
This one is all about the module we’re covering this week – Capital budgeting. Ron doesn’t understand the concept of the time value of money and how that is used in calculating the net present value of his new plant. It’s your job to explain it to him in language that he can understand – plain English, no accounting or finance jargon allowed!
- Explain to Ron what the Net Present Value (NPV) means in terms of his new plant. I did the calculations for you – using an interest rate of 6%, the project has a negative NPV of -$491,180 [$2,000,000 – $205,000 x 7.3601] – you must be able to calculate this yourself).
- Now talk about the Internal Rate of Return for Ron’s project and what that means. (Again, I number crunched for you: IRR = 0.45%) Hint: consider alternate uses for that money and the return it might earn if you invested elsewhere or even if you just left it in the bank (
- The calculated pay back for Ron’s project is 9.76 years. You must be able to calculate this yourself. Can you use that figure to try to convince Ron that this plant is just a bad idea?
I did the number crunching for you because I want the discussion to focus on the interpretation of the numbers rather than different opinions on what the calculations should be.
