In the business world, net present value is one of the most useful tools for making financial decisions. NPV is usually used to calculate whether a certain purchase or investment is worth more in the long run than a simple investment of an equivalent amount of money in the bank. While it is often used in the corporate finance sector, it can also be applied for day-to-day goals. Generally, it can be calculated with the following formula: (P / (1 + i)t) - C, for all positive integers up to t, where t is the number of time intervals, P the cash flow, C the initial investment, and i the discount rate. To understand how to perform the calculation step by step, read on.
Steps
Part 1 of 2: Calculate the NPV
Step 1. Determine your initial investment
In the business world, purchases and investments are often made with the goal of making a long-term profit. For example, a construction company might buy a bulldozer. This would allow her to accept larger projects and collect more income over time than she would have if she saved money and only took on small jobs. These types of investments generally have a single initial cost; to begin identifying the NPV of your investment, identify this cost.
For example, imagine running a small lemonade stand. You are considering the option of buying an electric juicer for your venture - it will save you more time and effort than it takes to squeeze lemons by hand. If the squeezer costs 100 euros, it is this sum that the initial investment amounts to. Over time, hopefully this tool will allow you to have more income than you would get without it. In the next steps, you will use this initial investment of $ 100 to calculate the NPV and determine if you should buy the juicer
Step 2. Determine a time range to analyze
As stated earlier, businesses and individuals make investments with the aim of making a long-term profit. For example, a sneaker company buys a shoe-making machine. The goal of this purchase is to generate enough revenue by using the tool to amortize the cost, and then make a profit before it breaks down or deteriorates. To determine the NPV of your investment, you need to specify a time frame during which you will try to determine whether the investment will pay for itself. This period can be measured in any unit of time, but years are used for serious financial calculations.
Taking the lemonade stand example, imagine you've done an online search to find out the specific features of the squeezer you intend to buy. According to most reviews, it works great, but usually breaks after about 3 years. In this case, you will use this time interval for the calculation of the NPV. This way, you will determine if the cost of the squeezer will be amortized before the time comes when it will be most likely to break
Step 3. Make a rough calculation of the cash flow for each time frame
Next, you need to estimate the profits your investment will generate during each time frame it will bring in revenue. These amounts (called cash flows) can be expressed through specific figures and notes or estimates. In the latter case, businesses and financial organizations put a lot of time and effort into getting an accurate estimate, hire industry experts, analysts, and so on.
Think back to the lemonade stand example. Based on your past performance and best future estimates, imagine that implementing the € 100 squeezer will allow you to cash in an extra € 50 in the first year, 40 in the second and 30 in the third; Plus, your employees will have to spend less time squeezing (as a result you will save money on salaries as well). In this case, your expected cash flows are: 50 euros in the first year, 40 in the second and 30 in the third
Step 4. Determine the appropriate discount rate
In general, a given amount of money is currently worth more than in the future. This happens because the money you have today can be invested in an account that will generate interest, thus acquiring value over time. In other words, it is better to have 10 euros today than 10 in a year, because you can invest this amount today and have more than 10 euros in a year. For NPV calculations, you need to know the interest rate of an investment account or opportunity with a similar level of risk to the one you are analyzing. All of this is summed up with the expression "discount rate", and is expressed in decimals, not a percentage.
- In corporate finance, the weighted average cost of capital of the firm is often used to determine the discount rate. In simpler situations, you can usually simply use the rate of return on a savings account, a stock market investment, and other possibilities that allow you to invest your money in place of the opportunity you are analyzing.
- In the lemonade stand example, imagine you are not buying the squeezer. Instead, invest the money on the stock market, where you are sure you can increase the value of the money by 4% annually. In this case, 0.04 (4% expressed as a percentage) is the discount rate that will be used for this calculation.
Step 5. Discounts the cash flows
Next, you need to weigh the cash flow value for each time frame you analyze. Also, you have to compare them to the amount of money you would make from an alternative investment over the same period. This process is indicated by the expression "discount cash flows", and is calculated using a simple formula: P / (1 + i)t, where P is the cash flow amount, i is the discount rate, and t is time. For now, you don't have to worry about the initial investment - you'll use it in the next step.
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Taking the lemonade example, you analyze 3 years, so you have to use the formula 3 times. Calculate discounted annual cash flows as follows:
- First year: 50 / (1 + 0, 04)1 = 50 / (1, 04) = 48, 08 EUR.
- Second year: 40 / (1 +0, 04)2 = 40 / 1, 082 = 36, 98 EUR.
- Third year: 30 / (1 +0, 04)3 = 30 / 1, 125 = 26, 67 EUR.
Calculate NPV Step 6 Step 6. Add the discounted cash flows and subtract the initial investment
Finally, to get the total NPV of the project, purchase or investment you are analyzing, you need to add up all the discounted cash flows and subtract the initial investment. The result of this calculation represents the NPV, which is the net monetary amount you will get from an investment compared to an alternative investment that gave you the discount rate. In other words, if this number is positive, you will earn more money than if you chose an alternative investment. If it is negative, you will make less profit. However, remember that the accuracy of the calculation depends on the accuracy of the estimates of future cash flows and the discount rate.
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For the lemonade kiosk example, the final estimated NPV value of the squeezer would be:
48, 08 + 36, 98 + 26, 67 - 100 = 11, 73 EUR.
Calculate NPV Step 7 Step 7. Determine whether or not to make the investment
In general, if the NPV of your investment is a positive number, then your investment will be more profitable than an alternative one, so you should accept it. If the NPV is negative, it would be better to invest your money elsewhere, so the proposed investment should be rejected. Note that these are just general ideas. In the real world, there are usually many more factors involved in the process to determine whether a certain investment is a good idea.
- In the example of the lemonade stand, the NPV is 11.73 euros. Since it is positive, you will probably decide to buy the juicer.
- Remember that this does not mean that the juicer will only make you 11.73 euros. Instead, it means that the tool will allow you to get the necessary return rate of 4% per annum, plus an additional 11.73 euros. In other words, the investment is 11.73 euros more profitable than the alternative one.
Part 2 of 2: Using the NPV Equation
Calculate NPV Step 8 Step 1. Compare investment opportunities based on their NPV
Calculating the NPV for multiple possibilities allows you to easily compare investments in order to determine which are more profitable than others. In principle, the investment characterized by the highest NPV is the one of greatest value, because its profit over time is higher than that of the resources currently available. For this, you usually have to prefer investments with the highest NPV first (assuming that you do not have enough resources to make every investment with a positive NPV).
For example, imagine you have 3 investment opportunities. The first has a NPV of 150 euros, the second of 45 euros and the third of -10 euros. In this situation, you would be the first to choose the investment of 150 euros because it has the highest NPV. If you have enough resources, you could switch to the $ 45 investment later, because the value is lower. Instead, you would let the investment of -10 euros lose, because with a negative NPV, it will generate less profits than an alternative investment with a similar level of risk
Calculate NPV Step 9 Step 2. Use the formula PV = FV / (1 + i)t to calculate present and future value.
Using a slightly modified formula compared to the classic NPV formula allows you to quickly determine how much a current amount of money will be worth in the future (or how much a future amount of money is worth in the present). Just use the formula PV = FV / (1 + i)t, where i is the discount rate, t is the number of time intervals analyzed, FV the value of future money and PV the value of money in the present. If you know the variables i, t and FV or PV, it is relatively easy to find the final one.
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For example, imagine you want to know how much $ 1000 will be worth in 5 years. If you are more or less aware that you can get a 2% return rate on this amount of money, you will substitute the variables like this: 0, 02 is i, 5 is t and 1000 is PV. Here's how to find FV:
- 1000 = FV / (1 + 0.02)5.
- 1000 = FV / (1, 02)5.
- 1000 = FV / 1, 104.
- 1000 x 1, 104 = FV = 1104 EUR.
Calculate NPV Step 10 Step 3. Research evaluation methods to get more accurate NPVs
As stated earlier, the accuracy of any NPV calculation essentially depends on the accuracy of the values you use for the discount rate and future cash flows. If the discount rate is similar to the true rate of return you can get from a similar risk alternative investment and the future cash flows are similar to the amounts of money you will actually make from the investment, the NPV calculation will be accurate. To make an estimated calculation of these values and bring them as close as possible to the real corresponding ones, you need to take a look at company valuation techniques. Since large firms often have to make huge multimillion-dollar investments, the methods used to determine if they are sound can be quite sophisticated.
Advice
- Always remember that other non-financial factors (such as environmental or social issues) may need to be considered in order to understand when to make an investment decision.
- NPV can also be calculated using a financial calculator or a series of NPV tables, useful if you don't have a calculator for estimating cash flow discounts.
