Calculating Net Present Value is rather simple and gives a profit/loss estimation of a project. Investopedia defines it as the difference between the present value of cash outflows and cash inflows. By finding Net Present Value (NPV), a person can decide whether a financial investment is worth the cost. A positive value indicates a profit, whereas a negative value indicates a loss.
- Skill level:
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Things you need
- Cost of initial investment
- Projected cash flows in future years
Add the amounts of the investment. This should include the initial cash outlay and any additional investments expected during the defined period.
Example: £7,800 initial investment plus expected £650 future investments equals £8,450 in a five-year project.
Determine the rate of return for the project. This is the discount rate for each year's cash flows. More elaborate calculations use the Required Rate of Return formula to find the acceptable discount rate.
Calculate Present Value (PV) for each year using the formula: cash flow (C) divided by (1+rate(R))^number of years (N). Since the first year would be the same as the standard discount rate (as it would be raised by itself), it would be the expected cash flow divided by one plus the discount rate in the form of a decimal. So a 15 per cent discount rate would be the cash flow divided by 1 plus 0.15 or 1.15.
Example: £1,950 first year cash flow at 10 per cent discount rate = £1,950 / (1+.10)^1 = £1,772 PV.
Find the present value for each subsequent year, raising the discount rate plus one to the power of the number of years. If a Present Value table is available, simply cross-reference the amount of cash flow with the discount rate and number of years to get the Present Value amount.
Example: £2,275 second year; £2,600 third year; £2,925 fourth year; £3,250 fifth year
$3,500 / (1+.10)^2 = £1,880 PV
$4,000 / (1+.10)^3 = £1,953 PV
$4,500 / (1+.10)^4 = £1,998 PV
$5,000 / (1+.10)^5 = £2,018 PV
Add the Present Value of all years together. Subtract the sum of the investments from the total Present Value. If the amount is a positive number, the project is a beneficial one. If it is negative, this indicates the return is less than desired.
Example: £1,772 + £1,880 + £1,953 + £1,998 + £2,018 = £9,622 Present Value.
$14,804 - £8,450 = £1,172 Net Present Value = good investment
Tips and warnings
- Use the bare minimum percentage profit that you would find acceptable for the project.
- Additional research should be done in addition to NPV for deciding whether a project is worthwhile.
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