The calculation should not be based on NPV

innogy Case: Smart Meters
New answer on Aug 27, 2020
2 Answers
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Anonymous A asked on Aug 26, 2020

After the Calculation for Total costs and savings, there's s an important note saying it should not be based on NPV. I didn't even remember to do that, but would like to understand why it would not be appropriate to do so in this case? Can anyone elaborate on it, please?

Thank you in advance!

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Anonymous updated the answer on Aug 26, 2020

Hey !

Let's be efficient, cases are easy with a structure!

GENERAL RULES: First calculate any future cash flow without considering the Present Value (PV) or Net Present Value (NPV). Then if you have time calculate the NPV of the future cash flow to be more accurate.


BASIC STRUCTURE

Formula

  • Profit = Revenu - Cost
  • Net Present Value (NPV) = Present Value - Investment

Definition

  • A Cash Flow is an amount of money you are going to get in the future (Future Value or FV)
  • The Present Value (PV) of a Cash Flow (CF) is his Future Value discounted by a discount rate R. We call that "discounted the cash flow".
  • The PV of a CF is the amount of money we need to put at a bank today with an interest rate R to get the same amount of money of the futur CF.

Example

  • Past revenu : historical revenu result
  • Futur revenu : revenu projected, revenu through market sizing you can get in 1 year



EXPLANATION
The revenu is a cash flow you are going to receive in the future.
So in theory if you calculate any revenu who is going to come in the future you should :

  1. Calculate this revenu - so his futur value
  2. Calculate the present revenu or "discount it" - change the futur into present value

But, in reality of cases, any "futur revenu" are considered as "revenu". It's a vocabulary simplification. And we don't calcule "the present revenue value" or don't discount it. So consequently we don't calculate the NPV.

We do this to save analysis time. That's why they suggest you "you should not be based on NPV".

Upvote if you find it helpful ;)

(edited)

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Ian
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Content Creator
replied on Aug 27, 2020
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Hi there,

A few key tips:

You should use NPV when:

  • They say we should calculate out into perpituity (i.e. forever)
  • They provide you with a discount rate, cost of equity/capital, etc.
  • There is a set growth rate (into perpituity)
  • They want a calculation into the next year or two
  • As a default (i.e. always say "I could do NPV if needeD"

You should not use NPV when:

  • You have offered and they say no
  • For any calculations that are >= 3 years or < inifinity

The reason? They don't expect you to do the crazy math that NPV requires further than to the power of 2/3.

In this case specifically, 15 years is an insane calculation that no-one could do by hand! As such, you can apply a flat rate.

Hope this helps!

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