Net present value calculations take into consideration future cash flows from an investment when assessing a new business opportunity. The formula discounts future cash flows back into current dollar value, providing an apples-to-apples comparison for new opportunities. The formula requires the use of actual cash flows, not accounting figures such as accounting.
Depreciation is a noncash expense accountants compute to show the use of assets by a company. This expense only represents use of a previously purchased asset. Because the company is not actually spending cash on the expense, it has no place in net present value calculations. Accountants therefore exclude all depreciation figures when computing the net present value calculation.
Accountants compute net present value by identifying all cash flows from a current or new business opportunity. Cash flows include acquisition cost, disposal cost for new assets, training costs and future income earned through sales generated from the new opportunities. Accountants total all cash flows by year. They apply a discount factor to the cash flows and then sum the difference. The result is the net present value for the opportunity.
For example, a company is looking to purchase a new machine for £1.0 million. Over the next three years, cash flow from the new machine will be £195,000, £211,250 and £227,500. The company can sell its current machine for £325,000; training costs are £29,250 for the new machine. Total cash flows for years 1 to 3 are £490,750, £211,250 and £227,500, respectively. The net present discount factors are 0.917431, 0.841680 and 0.772183 for years 1 to 3 respectively. The result is a net present value of £803,705.
Under the example in Section 3, the company would not purchase the new machine because the net present value is less than the purchase price of the new equipment. If a company were to include depreciation in the example above, the figure would be even lower. The problem introduced, however, is that the net present value would be artificially lower due to the inclusion of noncash expenses to the formula.