Attention shoppers! An NPV of zero does not necessarily indicate “bad investment.”
Previously, we discussed applications and limitations of using cash-on-cash (COCR) return as a metric for analyzing forestry and timber investments, as well as questions related to internal rate of return (IRR) and return on investment (ROI). This generated a question from readers related to net present value (NPV): “Should a negative NPV automatically kill a potential forestry investment?”
Short answer: NO. Let’s discuss.
NPV is the present value of future revenues minus the present value of future costs. It is a measure of wealth creation relative to the discount rate. So a negative or zero NPV does not indicate “no value.” Rather, a zero NPV means that the investment earns a rate of return equal to the discount rate. If you discount the cash flows using a 6% real rate and produce a $0 NPV, then the analysis indicates your investment would earn a 6% real rate of return.
Additionally, a negative NPV means that the present value of the costs exceeds the present value of the revenues at the assumed discount rate. Any investment will produce a negative NPV if the applied discount rate is high enough. So it makes sense to double check the estimated costs to look for opportunities to economize, to review the sources of revenue to seek potential enhancements, and to revisit the assumed discount rate.
Click here to register for “Applied Forest Finance” on February 7th in Atlanta. The course details skills and common errors associated with the financial and risk analysis of timberland and other forestry-related investments.
Brooks, Question related to the above Zero NPV blog : If you are trying to work out IRR and you finally get down to zero rate and still have negative numbers— I think this means that IF your inputs are correct you will lose money on that particular tract although there could be other reasons for buying it. Is that correct ?
Forest: thank you for the question and clarifying example. Yes, you are exactly right. At the end of the day, it’s a cash flow story. So if the outflow exceeds the inflow, then we are beyond the reach and salvation from a rock bottom discount rate, and the NPV will remain negative.