Net present value is the difference between the present value of cash outflows and inflows. This calculation is commonly used in capital budgeting and investing to determine the profitability of a prospective investment, project, or expense. The NPV formula is also used in the context of stocks and securities to help make investment decisions.
The time value of money is worked into the NPV formula through the discount rate, which can be determined based on your company’s cost of capital. For example, if your company has a loan at 8% and 6%, the weighted average cost of capital would be 7%. In addition, businesses can use their internal rate of return to determine if an investment is worth pursuing.
The goal of net present value is to pinpoint how the future cash flows are valued in money today. Each cash flow is discounted using your internal rate of return or discount factor, giving you an overall picture of how the investment performs compared to the upfront cost. This is important when choosing between different investments and projects, as you can pinpoint which option provides the highest rate of return.
The NPV formula involves a few different factors. First, you will need the expected cash flow. This could be the amount of revenue a project generates or income expected to be received. Next, you will need the required return or discount rate. If you don’t have a required return, you can use an industry benchmark, weighted cost of capital, or other standard.
Now, you will need to determine your initial investment. This is the amount of funds needed upfront to pursue the project. Include the full amount even if you are financing the project. The final value is time. You will need to determine the length of time for the investment. Putting these factors together results in the following NPV formula:
NPV = (Cash Flow / (1 + i)^t) – Initial Investment
Let’s say that you are considering purchasing a new piece of machinery. The machine is expected to last three years, cost $50,000, and generate $20,000 in revenue each year. Your company requires an 8% return on investment to pursue the investment. Here’s how you will calculate the present value of cash flows:
($20,000 / (1+.08)^1) + ($20,000 / (1+.08)^2) + ($20,000 / (1+.08)^3) = $18,519 + $17,915 + $15,877 = $52,311
Since the investment is upfront, it does not need to be discounted. This gives us a net present value of $2,311.
The net present value formula can quickly become complex, especially if you have varying cash inflows, cash outflows, and an extended time period. As a result, many companies use Excel or other calculators to complete the backend work of the calculation. This reduces errors and infuses efficiency and speed into your calculation.
Nevertheless, you still need to understand how to interpret the results of your net present value formula. The first test is to determine the value of the net present value. A positive net present value means that the investment will generate a return. On the contrary, a negative net present value indicates that cash outflows exceed the cash inflows.
Generally, most companies will refrain from pursuing an investment that doesn’t have a positive NPV. This means, that in the long run, the company will lose money based on the current value of inflows. If the NPV calculation doesn’t yield the results your company requires, you can adjust your initial investment or find ways to alter the cash inflows.
Net present value does have some notable limitations. For one, the discount rate used is subjective. One company might require a 10% return while another may only need a 5% return. Changing the discount rate will play a major role in the NPV calculation.
In addition, the initial cost of the investment can change. For example, let’s say you calculated a positive net present value based on a $50,000 purchase price. Your company has decided to move forward with the investment. Unfortunately, by the time you evaluated and purchased the investment, prices fluctuated. You now have a negative net present value.
Similarly, cash inflows can also change. There’s no telling how much revenue a new piece of machinery will generate years down the road. Customer demand, pricing, and technology can change at a moment’s notice. Although you can generate estimates based on past data, there’s no certainty that future results will match the inflows used in the calculation.
Payback period is a common alternative to net present value. This calculation measures how long it will take to recoup an investment. Let’s say that the initial investment is $60,000 and the expected cash flow is $15,000 per year. Dividing $15,000 by $60,000 generates a payback period of four years. This means that the investment will need four years to recoup the initial upfront costs.
One of the main disadvantages of payback period is that it does not take into consideration the time value of money. As a result, many companies will use both net present value and payback period calculations to determine the viability of an investment. However, when it comes to long-term investments net present value provides more value and insights.
Internal rate of return uses the same factors as the net present value formula. This formula solves for the discount rate, making net present value equal to zero. Internal rate of return is used to compare different project time spans. This method falls short because it doesn’t consider the impact of reinvesting capital.
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