Net Present Value (NPV) – Definition, Examples, How to do NPV?

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Net Present Value (NPV) is the total value of all the future cash flows, be it positive or negative, over the entire life of the investment which is discounted to the present. It is a form of intrinsic valuation that is used across all departments of finance and accounting to determine the value of certain things including business, investment security, capital project, new venture, cost reduction program and everything else that involves the flow of cash.

Net Present Value (NPV) – Definition and Examples:

NPV is used to determine the actual value of an investment or a project in terms of cash. It is an all-encompassing metric that takes into account all kinds of costs including expenses, revenues, and capital costs, all of these which are associated with FCF (Free Cash Flow). Additionally, it also determines the timing of each cash flow that might have a huge impact on the present value of the investment. It is always better to have cash flowing in sooner and flowing out later, as opposed to the opposite of that.

The cash flow that is present in the analysis of NPV is discounted for two primary reasons- firstly, it helps in adjusting the risks of an investment opportunity and secondly, it helps in keeping account the time value of money (TMV).

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The first point, that is, to adjust the risk, is important because not all business, investments and projects have a similar level of risk. Different types of projects will have different levels of risk naturally. For example, if you own a company that works in large scale, your cash inflow will not be similar to that of a new startup company. To keep the risks in check, the discount has to be higher for riskier investments and lower for the safer ones. So, investments are measured by how much more risk they will bear depending on that.

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The second point that is, keeping in account the time value of money is important because it helps in regulating the inflation, opportunity costs and the interest rates. Money is more valuable as soon as it is received. To explain it in short, the money that you have now is better than what you had five years ago. If the money is received today, it can be invested and you can earn interest on it which will be worth more than the current amount in the coming five years.

NPV Formula:

The NPV formula will help in calculating the Net Present Value of the series of cash flows which is based on a certain discount rate. It can be very useful when it comes to financial analysis and financial modeling, especially in analyzing the value of an investment, a company, a project or a cost-saving initiative. Given below is the formula of NPV for single cash flow:

Where:

Z1 = Cash flow in time 1

Z2 = Cash flow in time 2

r = Discount rate

X0 = Cash outflow in time 0 (i.e. the purchase price / initial investment)

NPV= Today’s value of the expected cash flows- Today’s value of the invested cash.

The positive value of NPV indicates that earnings that are projected and are generated by an investment or project will exceed the anticipated costs.  It is assumed that the investment which displays a positive value of NPV will be profitable. On the flip side, an investment that has a negative NPV will result in a net loss. This concept lies for the basis for the rule of NPV which shows that only the investments that have positive NPV values will be considered.

Apart from the formula, NPV can also be calculated using tables, spreadsheets, and calculators. Money in the present has more value than the same amount in the future. You might ask why? This is because of inflation and the earnings that are gathered from different investments which could be made during the intervening time. In other words, the dollar that you earn in the future will not be of same value or worth the amount that you have earned in the present. An investor might be willing to wait for an entire year so that he can earn an extra percent of money, but this might not be acceptable by all the investors out there. In this case, the extra percent is the discount rate which will differ depending on different investors.

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As the equipment cost is paid for in the very beginning, this is the first step to calculate the cash flow. Also, there is no elapsed time that you will have to take in consideration. You will first have to start with identifying the number of periods. After that, identify the discount rates.

Example:

Let’s have a look at the example given below that illustrates how to calculate Net Present Value of a series of cash flows. As you can see in the table given below, the assumption is that the investment will return $10000 annually for over a period of ten years and the rate of discount is 10%.

Year 1 2 3 4 5 6 7 8 9 10
Discount factor 0.91 0.83 0.75 0.68 0.62 0.56 0.51 0.47 0.42 0.39
Undiscounted Cash Flow 10000 10000 10000 10000 10000 10000 10000 10000 10000 10000
Present Value 9091 8264 7513 6830 6209 5645 5132 4665 4241 3855

The final result is that the value of this investment is worth $61,446 currently. This means that any rational investor would be willing to pay an amount of $61,446 to receive $10000 for a period of ten years. When the investor will pay this price, he will receive an internal rate of return of ten percent. And if he pays anything less than $61,000, he will earn an internal rate of return which will be greater than 10%.

The NPV relies on the discount rate of return that might have been derived from the cost of capital.

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