Investment is the key to every business. From inception to development of the business and expansion, capital is required. Based on the capital investment, the company will decide to expand. When doing so business needs to calculate the Net Present Value of future cash.
Definition of Net Present Value
As the name implies it is the net worth of the present cash flow including the cash inflow, cash outflow, discounted at a particular rate. NPV is the popular form by which is known in the accounting world.
It is important to calculate the net present value as it keeps the company informed about the value that any business adds keeping in the account about the money available to spend and the money that the business will generate.
NPV is a method used to estimate the worth of investment in any project.
How To Calculate Net Present Value?
There are different formulas used by people in corporate finance to calculate the NPV. It can be either done with the cash inflow or the cash outflow. Calculated using the cash inflow
NPV = ∑ (P / (1+i)t) – C
- C – Initial cost
- T – Time
- P - Cash inflow
- i – Discount rate
Calculated using the cash outflow When cash outflow is first used, use one of the present value formula to calculate the PV and then find the Net Present Value.
NPV = PV – Cash outflow PV = FV / (1+r)n
- PV – Present value
- FV – Future value
- r – interest rate
- n – number of periods
NPV = PV – Cash outflow PV = FV / (1+i)t)
What Inputs are Required to Calculate NPV?
From the above net present value formula, you can understand that there are a couple of ways it can be calculated. It requires the following basic details
- Initial investment
- Discount rate
- Net cash flows (after tax) for every project
What does NPV convey?
- Positive NPV is an indication to accept the project as there is a scope of getting profit.
- On the other hand, a negative NPV indicates a loss.
Examples of NPV calculation
Find some examples to understand NPV better.
NPV formula = ∑ (P / (1+i)t) – C
- The cost of the project is $2000(C) and offers four cash flows namely 500, 900, 1200, and 700 (P) for the next 4 years (t). The rate of return is 10% (i).
NPV = (500 / (1+0.10) + 900 / (1+0.10)2 + 1200 / (1+0.10)3 + 700/ (1+0.10)4) – 2000 The return rate is the discount rate (discount rate formula) i = 10 Period – 1, 2, 3, 4 (years) P – Cash flow – 500, 900, 1200, and 700 C – Initial cost – 2000 Calculation Find some examples to understand NPV better.
| Flow (P) | i | (1+i) | (1+i)^n | Calculation | |
| 500 | 1 | 0.1 | 1.1 | 1.1 | 454.54545 |
| 900 | 1 | 0.1 | 1.1 | 1.21 | 743.80165 |
| 1200 | 1 | 0.1 | 1.1 | 1.331 | 901.57776 |
| 700 | 1 | 0.1 | 1.1 | 1.4641 | 478.10942 |
| Total | 2578.0343 | ||||
NPV = (454.5 + 743.8 + 901.5 + 478.1) – 2000
2578.0343 – 2000
578.0343
In the above example, the Net Present Value is positive and thus seems to be a beneficial project.
- The initial cost is $50000 with a net cash flow of $5000 every month for 10 months. The rate of return is 10% yearly.
Initial Investment = $50000
Cash Inflow = $5000
Total Number of Periods = 10
Discount Rate/ Period = 10% ÷ 10 = 1%
= 5000 X (1 – (1+1%)-10/ 1% - 50000
= 5000 X (1 – 1.01-10) / 0.01 – 50000
= 5000 X (1-0.9053)/0.01 – 50000
= 5000 X (0.0947/0.01) – 50000
= 47356 – 50000
= - 2643
In the above case, it is not beneficial as the net worth value is negative and hence this investment is a loss to the business.
Discount Formula and Net Present Value
There is another scenario in which the discount formula is used to calculate the discount rate. It either uses
- the weighted average cost of capital (WACC)
WACC = E/V x EC + DC/V x Cd x (1-T)
E – Equity Value D – Debt Value EC – Equity cost DC – Debt cost V – E + D T – Tax rate
- adjusted present value (APV)
APV = NPV + PV
- Example – One company is looking at opening a new branch and the details of their investment are provided below. The initial investment is $5000
E – Equity Value – 2% D – Debt Value - 8% EC – Equity cost – 3.5% DC – Debt cost – 1.5% V – E + D T – Tax rate - 3.2% Cash flow
| Year 1 | 2 | 3 | 4 | 5 | 6 | 7 |
| -1200 | 1000 | 1100 | 1200 | 1300 | 1400 | 1500 |
Calculation
WACC = E/V x EC + DC/V x DC x (1-T)
= 1.08 x 0.035 + 0.81 x (1-3.2%)
= 1.08 x 0.035 + 0.81 x (0.968)
= 0.8122%
NPV formula = ∑ (P / (1+i)t) – C
1+i = 1.008
= -1200/1.008 + 1000/(1.008)2 + 1100 / (1.008)3 + 1200 / (1.008)4 + 1300 / (1.008)5 + 1400/(1.008)6 + 1500 / (1.008)7
∑ (P / (1+i)t)
C = 5000
| Cash Flow (P) | i | (1+i) | (1+i)^n | Calculation | |
| -1200 | 1 | 0.008 | 1.008 | 1.008 | -1190.4762 |
| 1000 | 1 | 0.008 | 1.008 | 1.01606 | 984.18997 |
| 1100 | 1 | 0.008 | 1.008 | 1.02419 | 1074.0168 |
| 1200 | 1 | 0.008 | 1.008 | 1.03239 | 1162.3559 |
| 1300 | 1 | 0.008 | 1.008 | 1.04065 | 1249.2251 |
| 1400 | 1 | 0.008 | 1.008 | 1.04897 | 1334.6422 |
| 1500 | 1 | 0.008 | 1.008 | 1.05736 | 1418.6248 |
| Total | 6032.5785 | ||||
NPV = 6032.5785 - 5000
NPV = $1032.5785
This investment is profitable for the business.
Observation
From the above scenarios, you can see that the same NPV formula is used to calculate the value but with a difference.
- In the first and third example the cash flow is different and the second one the cash flow remains the same.
- In the first and second example discount rate was given and in the third example discount rate was calculated using the discount formula.
Therefore, the calculation steps varied. Based on the different inputs available in your business you need to calculate the Net Present Value.
Bottom Line
Net Present Value is the best tool that takes the time value of money to calculate business profitability. It is a comprehensive tool that takes care of all the components of investment. The only drawback with this method is when it comes to calculating the discount rate which sometimes might mislead showing false profitability. But this can be overruled by using the right calculating app.
