Net present value is a way for managers to determine if they should undertake an investment in a project or if they should pass on the project. If the net present value if above 0, then the manager generally should undertake the project. This is because the project eventually provides the company with positive cash flows sometime in the future. Even with a net present value above 0, a manager may not undertake the project if he has other projects under consideration or capital restrictions.
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Determine the cash outflows related the project. For example, a company is deciding on a project that costs £3,250 initially to start the investment.
Determine the cash inflows from the project. In the example, the company expects £650 in year 1, £1,950 in year 2 and £3,250 in year 3.
Find the present value factor for each cash flow year using the present value of 60p table, located in the resources. Use the company's expected return as the interest rate and the year number as the period. In the example, if the company wants a 5 per cent return, then year 1 is 0.95238, year 2 is 0.90703, and year 3 is 0.86384.
Multiply the cash flow by the associated present value factor. In the example, £650 times 0.95238 equals £619.0 for year 1, £1,950 times 0.90703 equals £1,768.70 for year 2, and £3,250 times 0.86384 equals £2,807.4 for year 3.
Add together all the cash flows to calculate net present value. In the example, -$5,000 plus £619.0 plus £1,768.70 plus £2,807.4 equals £1,945.20. Since the number is higher than 1, the company will undertake the project since it gets the required rate of return.
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