How to Calculate NPV

In the business world, Net Present Value (aka NPV) is one of the most useful tools you can use to make financial decisions. ^{[1] X Source of Research} Typically, NPV is used to estimate whether a purchased or invested property is worth it over the long term, rather than simply investing the same amount in an investment account. savings at the bank. Although commonly used in the corporate finance world, it is also used for everyday purposes. In general, you can calculate NPV using the formula NPV = ⨊(P/ (1+i)t ) – C, where P = Cash Inflows at Specific Time, i = Discount Rate (or rate) rate of return), t = Time to calculate cash flow and C = Initial Investment Cost.

Table of Contents

Calculate NPV

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Determine the initial investment cost. This is the “C” of the above formula. In the business world, property values acquired and invested are often aimed at making money over the long term. This type of investment usually has an initial investment cost – usually the value of the property being purchased. ^{[2] X Research Source}

For example, imagine that you run a small lemonade stand. You are considering buying a juicer to save time and effort instead of using your hands to squeeze lemons. If the press costs $100, then this $100 is your initial investment.

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Specify the time period for analysis. This is the “t” in the above formula. As mentioned above, businesses and individuals invest for the purpose of making money in the long run. In order to calculate the NPV of your investment, you need to specify a specific time period when you proceed to determine if you will get a return on your investment. This period can be measured in units of time, but most financial calculations will use years. ^{[3] X Research Sources}

In our lemonade stand example above, let’s say we researched the juicer we plan to buy online. According to the majority of user reviews, the machine runs well, but often breaks down after about three years. In this case, we’ll use three years as the NPV calculation period to determine if the press will help you get your initial capital back before it broke down.

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Estimate cash inflows for each time period. This is the “P” in the above formula. You need to estimate how much money your investment will give you during the time it makes you money. This amount (also known as “cash inflow”) can be specific, known, or estimated. ^{[4] X Source of Research} In the latter case, from time to time, businesses and financial firms will devote a great deal of time and effort to making accurate estimates, hiring business professionals, analysts, etc.

Continuing with the lemonade stand example. Based on your past performance and your best estimate of the future, you would expect that using a $100 press will bring you an extra $50 in the first year, $40 in the second, and $30 in the third year by reducing the time employees spend squeezing lemons (and thereby, saving you on payroll costs). In this case, you expect your cash flow to be: $50 in year 1, $40 in year 2, and $30 in year 3.

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Determine the appropriate discount rate. This is the “i” value in the above formula. Generally speaking, in the present , your available funds will be worth more in the future. The reason is because you can save the money you have now and profit over time. In other words, owning $10 today is still better than $10 in a year because you can invest $10 now and get $10 more in a year. To calculate NPV, you need to know the rate of return of an investment account or opportunity that has a similar level of risk as the investment you are analyzing. It’s called the “discount rate” and is expressed as a decimal, rather than a percentage. ^{[5] X Research Sources}

In corporate finance, the average cost of capital of a business is often used to determine the discount rate. In a simpler situation, you can use the rate of return from your savings, stock investments, etc that you can invest in instead of going after the investment you are analyzing.
Going back to our lemonade stand example, if you didn’t buy the juicer, you would invest that money in the stock market, where you can feel confident your money will returns 4% per year. In this case, 0.04′ (decimal of 4%) is the discount rate we use in our calculation.

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Discount cash inflows. Next, we calculate the value of the cash inflows for each period we analyze compared to what we would have earned on the alternative investment over the same time period. This is called “discounting” cash flows and is calculated using the simple formula P / (1 + i) ^t , where P is the cash flow value, i is the discount rate, and t is the time time. We don’t need to care about the initial investment yet – we will use it in the next step.

Continuing with the lemonade stand example, we are analyzing with a period of three years, so we need to use the formula three times. You can calculate the discounted annual cash flow as follows:
- Year One: 50 / (1 + 0.04) ¹ = 50 / (1.04) = $48.08
- Year Two: 40 / (1 +0.04) ² = 40 / 1,082 = $36.98
- Year Three: 30 / (1 +0.04) ³ = 30 / 1.125 = $26.67

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Calculate the total discounted cash flow and subtract the initial investment. Finally, to calculate the NPV of the project, acquired asset, or investment you are analyzing, you need to add up all discounted cash flows and subtract the initial investment. The value you get will be the NPV value – the amount your investment will yield compared to another alternative investment that provides you with a discount rate . In other words, if this is a positive number, you will make more money than if you used it on another alternative investment, like the hypothetical 4% you could earn in the stock market in the example. above. If this is a negative number, you will make less money.

For our lemonade stand example, the final NPV of the juicer project would be:
- 48.08 + 36.98 + 26.67 – 100 = $11.73

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Determine whether you should invest. In general, if your investment has a positive NPV, it will be more profitable than spending money on another alternative investment and you should accept it. If the NPV value is negative, it is best to invest your money elsewhere, and should discard the investment you are planning to make. Keep in mind that these are general guidelines only – in practice, you will often have to focus more on the process of determining whether an investment is a wise idea.

In the lemonade stand example, the NPV is $11.73. Since this is a positive number, we can decide to buy a press.
Remember that this does not mean that the lemon juicer will only set you back $11.73. In fact, it means that the press will give you a 4% annual return, plus $11.73. In other words, it will be more profitable than the alternative investment of $11.73.

Use cash outflow to calculate NVP

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Calculate the value of the company’s profits over a certain period of time using the PV equation. In many cases, you need to consider the costs that are frequently incurred (such as the cost of purchasing goods or the cost of maintenance). In these cases, use the following equation to calculate the profit over a given period:

P

DRAW

=

F

DRAW

/

(

first

+

r

)

n

{displaystyle PV=FV/(1+r)^{n}}

{displaystyle PV=FV/(1+r)^{n}}

. Where PV = present value, FV is the future amount you hope to earn over that period, r is the rate of return or interest rate, and n is the number of cycles you are currently working on. consider. ^{[6] X Research Source}

For example, let’s say you hope to earn $2000 in 10 years, with a 3% rate of return. The present value of this amount is $2000$ $/$ $($ $first$ $+$ $.03$ $)$ $ten$ $=$ $1488.18783$ ${displaystyle 2000/(1+.03)^{10}=1488.18783}$ ${displaystyle 2000/(1+.03)^{10}=1488.18783}$ , about $1,488.19.

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Add up the expected costs to find the cash outflow. To get a better idea of your present value, add up the expenses you need to pay. For example, you may have to pay for maintenance, supplies, or expenses related to running the business. Add up these costs to find the cash outflow for the period under consideration. ^{[7] X Research Sources}

For example, let’s say you need to invest $150 in a piece of equipment in your home store, then pay $50 in maintenance every 5 years. The cash outflow over that 10 year period is $150 + $50 + $50 = $250.

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Subtract the present value from the cash outflow to find the NPV. Net present value is the difference between present value and expected cash outflows, or total costs, for that period. Example: ^{[8] X Research Source}

If your PV value is $1488.19 and you expect cash outflows to be $250, then NPV = $1488.19 – $250 = $1238.19.

Using the NPV . equation

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Compare investment opportunities by NPV value. Calculating the NPV for a variety of investment opportunities allows you to easily compare your investment methods to determine which is more valuable. In general, the investment with the highest NPV value will be the most valuable because it provides the most return. For this reason, you should first pursue the investment with the highest NPV (assuming that you do not have the resources to make every investment measure with a positive NPV). ^{[9] X Research Source}

For example, we have three investment opportunities. One opportunity has an NPV of $150, one is $45, and one is -$10. In this situation, we would pursue the $150 investment first because it has the highest NPV. If we have enough resources, we can make a second $45 investment because it is less valuable. We shouldn’t make a -$10 investment because with a negative NPV it won’t give you more profit than investing in something else with a similar level of risk.

Advice

It should be remembered that there may still be other non-financial factors (such as environmental or social issues) that you should consider when making any investment decisions.
You can also calculate NPV using a financial calculator or NPV spreadsheet, which are useful if you don’t have a calculator available to calculate discounted cash flows.

Warning

Avoid making financial decisions without considering the time value of money.

Things you need

Pencil
Paper
Computer

Steps