What to include in a Net Present Value (NPV) model
The general rule is that an NPV model should include all costs and benefits that would be affected by the decision to be taken. These are referred to as being the relevant costs and benefits. Irrelevant costs and benefits should be excluded on the grounds that that they could alter the decision for spurious reasons. At best they would add unnecessary work and modelling complexity.
The table below identifies typical examples of relevant and irrelevant costs and benefits in the case of a model designed to support a project go/no go decision.
Examples of relevant and irrelevant NPV model components for a company project
Relevant costs and cost deductions
Relevant benefits and benefits deductions
Since the circumstances of projects vary, the lists above are not exhaustive. Nor do all of the types of cost and benefits apply in all cases. For example, the tax implications listed in the table would be irrelevant to government projects and might be accounted for differently by a company. There are also some items in the table for which further explanation might be useful:
- Financing costs are irrelevant because the discount rate is used to represent the implications of the cost of capital.
- Sunk costs are irrelevant because a decision today can only affect future cost and benefits. The fact that significant funds have already been invested in a project does not improve the business case for continuing it.
- A project may have significant opportunity costs that are not included in its own budget. An example is the use of assets such as land facilities owned by the organisation that, if used by the project, would close the opportunity of using them for other beneficial purposes.
- Increased turnover is not itself normally of benefit to a company. It would, for example, be possible to increase turnover at the expense of profit by decreasing prices. If an organisation exits to make profits, the value of a project is usually estimate on the basis of the effect on profit.
- It is often best practice to base the estimation of commodity-related benefits on current market rates. This rules future market price escalation as (relative to inflation) as being irrelevant. The key reason for this is that direct investment in the market for the relevant commodity is likely to be a more efficient method of exploiting the forecast market change than sponsoring a project.
These are not iron rules. For example, a different position would usually be taken on turnover by governments or charities. The identification of relevant benefits should be linked to the sponsor's articulation of project objectives and should be kept under constant review.