What is Net Present Value (NPV) and How to Calculate It
Many businesses are aware that the money they have at hand is more valuable than the money they are expecting to collect at a point in the future. Businesses use the money to make more money, either through buying inventory and selling it at a higher price or by investing for future returns.
How do you decide at what point to invest in your business? As a company expands, it faces important decisions it has to swiftly respond to around capital investment. Decisions revolving around the expansion of business and immense capital investments should be handled very wisely.
Net Present Value (NPV) helps you decide if your investment was worth spending your business money on.
In this article, you will learn the meaning of net present value (NPV), what companies use NPV for, how to calculate the net present value using NPV formula with examples, how to use the NPV formula in Excel, common mistakes when calculating and using NPV, net present value drawbacks nd alternatives, and net present value vs internal rate of return.
Let’s get started.
What is Net Present Value (NPV)?
Net Present Value or NPV for short is the present value of cash flows at the required rate of return for your project compared to the initial investment you put in. It refers to a method used to calculate the return on investment (ROI) on a project.
NPV simply looks at the money a business expects to generate from an investment and translates it into today’s monetary value. Businesses use the net present value to determine whether a project is worth it or not. It is one of those small business bookkeeping basics that every business should know.
Another rich definition of Net Present Value (NPV) is that it is the difference between the present value of cash inflows and cash outflows over a given timeframe. It is a key metric used for capital budgeting and investment planning. The Net Present Value analyzes the profitability of a project or projected investment.
Net Present Value (NPV) calculates the current total value of a future stream of payments. It reflects the time value of money and is also used to compare other investment alternatives.
This key metric relies on a discount rate. This discount rate may be derived from the cost of the capital needed for the investment.
If the Net Present Value (NPV) of an investment or project is positive, it means that the discounted present value of all future cash inflows and outflows relating to that investment or project will also be positive. Investments or projects that have a negative NPV are not attractive and should be avoided.
What Do Companies Use the NPV For?
1. To Ascertain the Viability of a Project or Investment
Companies use Net Present Value (NPV) to compare projects or investments and decide which ones are worth pursuing. It helps companies evaluate whether the investment is worth the money.
The Net Present Value is not the only option available for comparing projects or investments for companies and managers, other options include internal rate of return and payback method.
The Net Present Value (NPV) is the preferred choice by most financial analysts for comparing investments or projects.
There are two reasons why NPV is the tool of choice for companies. One, it considers the time value of money by translating future cash inflows and outflows into today’s dollars. Two, it gives a substantial number that companies can use to compare their initial investment or cash spend against the present value of the return.
2. For Mergers, Acquisitions, and Purchases
Managers use the Net Present Value (NPV) to decide whether to make large purchases such as software and equipment. Since capital expenditures usually involve a considerable sum of money with benefits that stretch into the long haul, it is wise to consider the NPV of investments you want to acquire.
Companies also use it for mergers and acquisitions. When the NPV is used for mergers and acquisitions, it is called discounted cash flow.
By analyzing and comparing the various options, you can find the most viable ones to invest in and the ones with little or zero prospects to avoid.
Knowing how to calculate and use NPV can help companies take smart risks, grow their business, make sound investment decisions, and avoid financial difficulties.
How to Calculate Net Present Value Using NPV Formula (Including Examples)
To calculate NPV, you need to estimate future cash flows for each period and determine the correct discount rate.
The formula for NPV is:
NPV = Cash Flow / (1+i)t − Initial Investment
i = Required return or discounted rate
t = Number of periods
The outcomes for Net Present Value can either be positive or negative. If the outcome is positive, it is an indication that the project is ideal for investment, while if the outcome is negative, it is an indication that it should be abandoned as it will ultimately drain cash from the company.
The higher the positive Net Present Value outcome, the more beneficial the investment or project is to the company.
Regarding the discounted rate, it is important to factor in how you obtain funding for the project. If you are funding through high-interest loans, consider it when determining the net present value.
The discounted rate is company-specific and relates to how the company gets its funds. It is either the rate of return that you expect to receive on your investment or the cost of borrowing money. For example, if a company expects a 10% return from an investment, it becomes the discounted rate the company uses to calculate its Net Present Value.
Also, if the company is to pay a 5% interest on money it borrowed from a financial institution, that figure becomes the discounted rate for calculating the Net Present Value.
If you are analyzing a longer-term project with multiple cash flows, use this formula.
NPV = Rt / (1 + i)t
Net Present Value = ∑ Year and Total Cash Flow / (1 + Discount Rate)n
If you are unfamiliar with the previous two formulas, here is an easy way to calculate the Net Present Value (NPV).
NPV = TVECF − TVIC
TVECF = Today’s value of the expected cash flows
TVIC = Today’s value of invested cash
An accounting software provider engages in a project that costs $10,000 and generates three separate cash flows of $5,000, $3,000, and $8,000 over the next three years. Assuming the required rate of return is 10%, what is the Net Present Value (NPV)?
NPV = Cash Flow / (1+i)t − Initial Investment
We can break the NPV formula to calculate each cash flow individually.
NPV = $5,000 / (1 + 0.10)1 + $3,000 / (1 + 0.10)2 + $8,000 / (1 + 0.10)3 – $10,000
NPV = $5,000 / 1.10 + $3,000 / 1.21 + $8,000 / 1.331 – $10,000
NPV = $4,545.45 + $2,479.34 + $6,010.52 – $10,000
NPV = $3,035.31
A payroll software provider is considering two potential projects. The first project requires an initial investment of $20,000 and is expected to generate revenues of $10,000, $8,000, and $15,000 for the first three years respectively with the target rate of return set at 12%.
The second project requires an initial investment of $20,000 and will generate $15,000 per year for two years with its target rate of return set at 12%. What is its Net Present Value (NPV)?
NPV = Cash Flow / (1+i)t − Initial Investment
NPV for the First Project = $10,000 / (1 + 0.12)1 + $8,000 / (1 + 0.12)2 + $15,000 / (1 + 0.12)3 – $20,000
NPV for the First Project = $10,000 / 1.12 + $8,000 / 1.2544 + $15,000 / 1.404928 – $20,000
NPV for the First Project = $8,928.57 + $6,377.55 + $10,676.70 – $20,000
NPV for the First Project = $5,982.82
The Net Present Value for the first project is $5,982.82.
NPV for the Second Project = $15,000 / (1 + 0.12)1 + $15,000 / (1 + 0.12)2 – $20,000
NPV for the Second Project = $15,000 / 1.12 + $15,000 / 1.2544 – $20,000
NPV for the Second Project = $13,392.86 + $11,957.91 – $20,000
NPV for the Second Project = $5,350.77
The Net Present Value of the second project is $5,350.77.
How to Use the NPV Formula in Excel?
You can calculate the Net Present Value (NPV) either by hand or with the use of a calculator. However, these methods make the Net Present Value harder to calculate and they are prone to errors. Most financial analysts use Excel to calculate NPV.
Here is an example of how to use the Net Present Value (NPV) function in Excel.
Step 1: Set a discount rate in a cell.
Step 2: Establish a series of cash flows (must be in consecutive cells).
Step 3: Type “=NPV(“ and select the discount rate “,” then select the cash flow cells and “)”.
Common Mistakes When Calculating and Using NPV
1. Difficult to Explain to Others
The most obvious problem when calculating and using Net Present Value (NPV) is that it is hard to explain to others. The discounted value of future cash flows is not a phrase that has much meaning to those unfamiliar with accounting.
Despite the difficulty with explaining the Net Present Value to others, it is worth the extra effort to explain it because of its benefits for companies and shareholders.
Any investment that passes the NPV test will most likely increase the value of the company’s or shareholder’s investment. Any investment that does not pass the NPV test (has a negative value) will hurt the company’s and the shareholder’s investment.
2. Based On Several Assumptions and Estimates
Net Present Value (NPV) is based on several assumptions and estimates which leave lots of room for error if you are not careful.
Double-checking your NPV calculation can help mitigate the risks of making errors. You can also carry out sensitivity analysis after you have calculated the initial NPV calculation.
There are three areas where you stand the most risk of making mistakes when calculating your Net Present Value. A misestimate by the digit to any of these areas will drastically affect the results of your NPV calculation.
The first area is the initial investment. If you are purchasing a piece of equipment with a clear price tag, it is easy to know your initial investment.
However, if you are upgrading your business system to use an ERP system, you can easily make a mistake because of the cost variance.
The second area is the discount rate. There is a great risk using today’s discount rate to calculate your future returns especially if it is not fixed. The discount rate for the first year may not be the same for the third year of the project.
Interest rates if you took a loan can spike, causing your costs to increase. What this means is that your estimated returns for that year will be lesser than what you initially calculated.
The third area companies make mistakes when calculating and using the Net Present Value (NPV) is in estimating the projected returns of your projection.
3. Discounting the Time Zero Investment
The time zero is the nominal or real value of your investment so there is no need to discount it. However, it is not uncommon for companies or individuals to accidentally discount the time zero investment amount.
Because the zero investment amount represents the cash investment and it is always a negative cash flow, discounting it deliberately or accidentally means you are reducing the size or value of your investment. It also means that you are discounting the future period positive cash flows twice.
The danger of discounting the time zero investment is that you make your project’s Net Present Value (NPV) lower than it actually is.
To avoid misleading Net Present Value, do not discount the time zero value when calculating the NPV formula either by hand, calculator, or Excel. The only values you should discount are the future and non-time zero values.
Net Present Value Drawbacks and Alternatives
Business analysts make use of the Net Present Value (NPV) to gauge an investment’s profitability. NPV relies heavily on estimates and assumptions, which can leave room for error. Estimated factors such as discount rate, investment costs, and projected returns are prone to errors if not carefully calculated.
A project may require unforeseen expenditures to get it started or extra expenditures at the end of the project, which can cause the calculated Net Present Value (NPV) to be inaccurate.
Although the Net Present Value (NPV) is a key metric used by companies and accountants for determining the Return On Investment (ROI), it has its fair share of drawbacks.
The reason why there is so much room for errors when calculating the Net Present Value is that the calculations are based on educated estimations. These estimations are based on past and current expenditures.
When calculating the Net Present Value, you have to consider whether the valuation of the project or investment is accurate. The accuracy of the project or investment depends on the current market conditions, the possibility of tariffs, the potential for price increases, and the potential for cost overruns.
When purchasing equipment with a definite price, the Net Present Value is easy to calculate as there are not many variations. However, problems arise when you are dealing with a project or investment where the hard cost is variable.
Another drawback of using the Net Purchase Value is that the discounted rate may not truly reflect what happens in the future. Changes in the market due to demand, supply, and other factors can either hinder or be a massive advantage to the bottom line.
Return On Investment (ROI)
Return on Investment (ROI) is a Net Present Value (NPV) alternative that measures how profitable an investment is. Companies use the Return On Investment (ROI) to decide where to invest their profits.
The formula for calculating Return On Investment (ROI) is:
ROI = (Net Profit / Cost of Investment) x 100
Companies use ROI to gauge the profitability of their businesses, assets, and to determine returns from their investments in company shares. It measures the investment gains relative to the cost of investment.
For example, if a company invests in a virtual phone system for $1,500 and sells it later for $2,000. What is its Return On Investment (ROI)?
ROI = (Net Profit / Cost of Investment) x 100
Net Profit = Total Revenue from Investment – Cost of Investment
Net Profit = $2,000 – $1,500
Net Profit = $500
ROI = ($500 / $1,500) x 100
ROI = 33.33%
The payback period or payback method is an alternative to Net Present Value (NPV). It calculates how long it takes for the original investment to be repaid. It is strictly limited to how much time it takes to generate the initial investment costs.
The problem with using the payback period or method is that it fails to account for the time value of money. Due to this, using payback periods to calculate long investments tends to be inaccurate. Also, comparisons using payback periods do not take into account the long-term profitability of investments.
The formula for calculating the payback period is:
Payback Period = Initial Investment / Annual Cash Inflow
Net Present Value vs Internal Rate of Return
Net Present Value and Internal Rate of Return both use cash flow as the basis for measuring the performance of investments. They both consider the time value of money, offer a clear framework for decision-making, and use financial goals and plans based on subjective assumptions.
Here are the differences between Net Present Value and Internal Rate of Return.
Net Present Value (NPV) refers to the present value of cash flows at the required rate of return for your project compared to the initial investment you put in. Internal Rate of Return (IRR) refers to the rate at which cash inflows are equal to cash outflow. IRR is a key metric
Internal Rate of Return (IRR) is represented in percentage terms while Net Present Value (NPV) is represented in absolute terms.
3. What They Indicate
Net Present Value indicates surplus from a project or an investment while Internal Rate of Return is the break-even point of a project or investment where there is no loss or profit.
4. Rate for Reinvestment
Net Present Value uses the cost of the capital rate as its rate for reinvestment, while IRR uses the internal rate of return as its rate for reinvestment.
5. Variable Cash Outflows
Variable cash outflows have different effects on NPV and IRR. It does not have an impact on the NPV but results in negative or multiple IRR.
Net Present Value FAQ
Net Present Value (NPV) is defined as the present value of a series of cash flows, after the investor’s required rate of return is discounted. It is the result of calculations used to find the present value of a future stream of payments by accounting for the time value of money.
Financial analysts use It as an analysis tool to decide whether an investment is worth taking a risk on.
IRR stands for internal rate of return. IRR estimates the profitability of a potential investment using a percentage value rather than a dollar amount and often does not account for external factors like inflation.
NPV on the other hand does not use a percentage value but a dollar amount and takes into account external factors such as inflation.
The advantage to using the NPV method over IRR is that NPV can handle multiple discount rates, in the long run, without any problems.
If an analyst is evaluating a single project or more than multiple projects that share a common discount rate, and cash flows, IRR will work. But it becomes very ineffective when these projects are calculated in the long term and do not share the same discount rates and cash flows.
NPV, on the other hand, allows each year's cash flow to be discounted separately from the others making NPV the better method.
Future cash flows have to be discounted because of the theory of the time value of money. The time value of money (TVM) is the concept that money you have now is worth more than the identical sum in the future due to its potential earning capacity.
What this means is that when the interest rate is accounted for, $10,000 a year from now is not worth as much as $10,000 today. For example, if after a year with a 5% interest rate you have $10,500, your money has maintained its buying power. Anything less, and it has lost its value.
Having an NPV of zero means that the cash inflows of the project are exactly equivalent to the cash outflows. The funds, while invested in the project, are earning at that rate of interest, which means the investor will be no richer or poorer after the calculated time.
From a financial point of view, it does not look like an attractive investment, but there are situations where profit is not the primary goal of a project so zero NPV is acceptable.