Net present value

From Supply Chain Management Encyclopedia

Net present value (NPV) is the worth in current monetary units of a time-based stream of incoming and outgoing cash flows. A number of supply chain decisions can be evaluated using the NPV model. The terms in the model include the net cash flow (Ct) at each time period (generally a year), the initial investment (Co), and the discount rate (r). The discount rate is also called the rate of return, the hurdle rate, or opportunity cost of capital. If the NPV of an investment is positive, then the investment should be undertaken. If several alternatives exist, then the alternative with the highest NPV should be selected.

Failed to parse (lexing error): \mbox{Net present value}\

Where:

• Ct = net cash flow (inflow minus outflow) at time t
• Co = initial investment, if any
• r = the discount rate

Example: An Investment that Reduces the Level of Iinventory

Suppose the average replacement value of inventory (v) at a warehouse is €150 million and the inventory carrying cost rate (c) is 40%. The annual carrying cost = c x v =.40 = €60 million. A one-time software investment of €5 million and an ongoing cost of €.5 million (for training, minor upgrades) is estimated to reduce inventory by 5%. The software lifespan is 3 years, after which it becomes difficult to predict whether an additional major investment will be necessary. The required rate of return (r) equals 10%. The critical question is whether the investment is worthwhile. The NPV model may be applied to understand whether the software should be adopted. As seen in applying the NPV model, the initial investment at time zero (Co) equals €5 million. During the first year the inflow equals the savings generated by the reduced inventory level (annual inventory carrying cost x percentage reduction in inventory = €60 million x .05 = €3 million) minus the additional annual expense of the software (€.5 million) divided by the present value of the discount rate (1.11). The NPV of the investment equals €1.21 million and the investment is worthwhile since the NPV is greater than zero.

• NPV = (3-.5)/1.1¹ + (3-.5)/1.1² + (3-.5)/1.1³ - 5 = 2.27+2.07+1.87-5 = 1.21