Net Present Value Explained with Formula and Examples
Do you sometimes wonder why money in hand now is more valuable than the money you will have in future? It is because, with the money you have at this moment, you can multiply it by investing in something or selling an asset.
The money you will have in future is firstly uncertain, as it can be affected by inflation that decreases its buying power. So, if you want to compare the value of money you have now with the money you will acquire in the future, you need to know what net present value is (NPV).
Keep reading to know more!
What is Net Present Value (NPV)?
Net present value (NPV) is the overall value of all the future cash flows, whether positive or negative. It is a method to calculate your return on investment (ROI) for an expenditure. This is a financial modelling method that accountants use for capital budgeting.
In other words, this is the difference between the present value of cash inflows and cash outflows over a fixed period. Analysts and investors also use NPV to evaluate the probable profit limits of their proposed projects.
What Is Positive and Negative NPV?
Positive net present value occurs when the projected earnings that any investment or project generates exceed the expected costs. The opposite of this is the negative NPV.
Since the latter can result in a net loss, it is always wiser to invest with a positive NPV. This is because it will be profitable.
What Is the NPV Formula?
To calculate multiple periods of projected cash flows, one can use this net present value formula to find the present value of each time.
Cash Flow
NPV = Σ
(1+i)
“i” represents the discount rates or required returns
“t” represents the number of time periods
Pros and Cons of the NPV
|
Pros |
Cons |
|
The time value of money is taken into consideration |
Dependent on inputs, estimates and long-term projections |
|
Inclusion of discounted cash flow using the company's capital cost |
This does not consider project size |
|
Easy to interpret as it returns a single dollar value |
As quantitative inputs drive it, there is no consideration for nonfinancial metrics |
|
Easier to calculate by using calculators and spreadsheets |
Difficult to calculate manually |
Example of Net Present Value (NPV)
To understand the functioning of NPV, we can compare two projects to invest in and keep its discount rate at 10%.
Project 1
|
Initial investment |
$10,000 |
|
Discoun trate |
10% |
|
Year 1 |
$5,000 |
|
Year 2 |
$15,000 |
|
Year 3 |
$9,000 |
|
Year 4 |
$18,000 |
|
Year 1 |
5,000/(1 + .10)^1 = $4,545 |
|
Year 2 |
15,000/(1 + .10)^2 = $12,397 |
|
Year 3 |
9,000/(1 + .10)^3 = $6,762 |
|
Year 4 |
18,000/(1 + .10)^4 = $12,294 |
Now to find the net present value for this project, we need to find the summation of these values and subtract the initial investment cost.
NPV = ($4,545 + $12,397 + $6,762 + $12,294) - $10,000
Therefore, NPV = $25,998
Project 2
|
Initial investment |
$5,000 |
|
Discount rate |
10% |
|
Year 1 |
$8,000 |
|
Year 2 |
$16,000 |
|
Year 1 |
8,000/(1 + .10)^1 = $7,273 |
|
Year 2 |
16,000/(1 + .10)^2 = $13,223 |
So, the resulting formula after calculating the present value for each cash flow and time:
NPV = ($7,273 + $13,223) - $5,000
Therefore, NPV = $15,496
As we compare the net present value of both these projects, the former is $25,998 while the latter is $15,496. Therefore, according to this result, the company should invest in Project 1 as it has a higher value.
Why Is Net Present Value (NPV) Analysis Used?
Net present value analysis is used to calculate the worth of any investment, project or cash flow series. This is an all-encompassing metric as it considers all expenses, revenues and capital costs that are linked with an investment in its Free Cash Flow.
Along with considering all kinds of costs and revenues, it also checks the timing of each cash flow. Thus, creating an impact on the present value of an investment.
Why Are Cash Flows Discounted?
Here are the following reasons why cash flows are discounted:
Adjusting to the Risk Factors of an Investment
As the risks of businesses, projects or other investment opportunities vary from one another. Therefore to counter the risks, the discounted rate is higher for investments that are more prone to risks. In contrast, the rate is lower for those investments which are much safer.
Incorporating the Time Value for Money
It is essential to include the TVM because the value for money is more as soon as one receives it. Otherwise, there are many factors that affect the value of money like inflation, interest rates, and other opportunity costs.
How to Calculate NPV Using Excel?
Since the net present value is the core element of budgeting in a company, no one usually calculates it manually. However, in Excel, there is a function to find this value. You just need to enter the stream of costs and benefits.
In Excel, you get two functions to calculate the Net Present Value: NPV and XNPV. Both functions use the same formula; only the difference between these two is:
NPV assumes all cash flows in a series occur at regular intervals, like monthly, yearly, quarterly, etc.
XNPV allows cash flow to occur on specific dates. Hence the series can be at irregular intervals.
As you have read so far, you know what net present value is (NPV). Practically, it is just a method to calculate your ROI. It is mostly used to compare projects and choose which one is more profitable. However, scholars suggest that using NPV as a tool is up to an analyst, as there are certain drawbacks.
