NPV stands for net present value. It's one way of estimating whether you will make a profit from an investment by calculating the likely return each year in today's value and comparing it with the return you could receive elsewhere. Several financial websites have an NPV calculator and Microsoft's Excel spreadsheet software has the NPV formula built-in, as do most financial calculators. You can also use NPV tables online or offline to help with the calculation (see Resources). However, it's useful to know how to calculate the NPV manually using a simple calculator when other solutions aren't available.
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Things you need
- Initial cost
- Expected income each year
- Number of years of investment
- Interest rate for each year
Calculate the present value (PV) for each year of the project. The formula for PV is Income/(1 + interest rate)^t, where t stands for the year of the project and Income means Return minus Cost. Therefore, for a project with an expected income of £650 in year 2 and an interest rate of 5 per cent, the PV is 1000/(1 + 0.05)^2, which equals 1000/1.05*1.05 which equals 1000/1.10, or £590. This is another way of saying that £650 now is worth £590 in 2 years' time if the interest rate (the amount you could earn if the money was invested on deposit instead) is 5 per cent a year.
Add together all the PV calculations. Continuing the previous example, if the interest rate remains the same for each year, the PV for year 1 is £618 (1000/1.05), the PV for year 2 is £589 (1000/1.103) and the PV for year 3 is £561 (1000/1.158). The sum of the PVs is therefore 952 + 907 + 864, or £1,769.
Deduct the initial cost. The PV calculations start from the end of year 1, so you need to deduct the initial investment. For this example, the initial investment is £1,300. The sum of the PVs minus the initial investment is therefore 2723 - 2000, or £469. This final figure is the net present value (or NPV).
Evaluate the answer. If the NPV is less than 1, the project is not profitable and you should not undertake it, as you would get a better return by putting your capital on deposit. If the NPV is greater than 1, the project initially looks profitable and you should investigate it further. In the example the NPV is £469, which indicates that by investing your £1,300 in this project you would be better off than if you had put it on deposit at 5 per cent interest for 3 years.
Tips and warnings
- NPV is only an initial indication of whether an investment may be profitable or not. Amongst other things, it doesn't take the financial risk of the project into account.
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