A summary of the advantages and disadvantages of applying and interpreting NPV generally and for forestry investments.

Net present value (NPV) compares the value of cash flows (benefits) received in the future with the capital required for investment today.  The decision rule is to accept and pursue projects with NPVs greater than or equal to zero, as this implies the project meets or exceeds your “hurdle” rate or expected rate of return. [Though a zero or negative NPV does not necessarily signal “bad investment.”]

The use of NPV as an investment and capital budgeting criterion features key advantages and disadvantages.

Advantages include:

• NPV provides an unambiguous measure. It estimates wealth creation from the potential investment in today’s dollars, given the applied discount rate.
• NPV accounts for investment size. It works for comparing marginal forestry investments to multi-billion-dollar projects or acquisitions.
• NPV is straightforward to calculate (especially with a spreadsheet).
• NPV uses cash flows rather than net earnings (which includes non-cash items such as depreciation).
• NPV recognizes the time value of money (unlike cash-on-cash returns or simple payback period). For forestry investments, which tend to be long-term, this is critically and entirely appropriate.
• NPVs are additive. If you have multiple projects and excess capital, you can add up projects to get a sense of aggregate wealth creation from all investable projects.

Disadvantages include:

• A discount rate must be selected. NPV also assumes the discount rate is the same over the life of the investment or project.  Discount rates, like interest rates, can and do change year-to-year.  Consider capitalization (“cap”) rates in commercial real estate.  Benchmarks move.  Opportunity costs change and differ across investors.
• NPV assumes you can accurately assess and predict future cash flows. While your crystal ball may prove infallible, mine has shown cracks at times.
• For some, it is an intuitively difficult concept to grasp.

 

This post includes excerpts from the book Forest Finance Simplified.