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How to Calculate NPV (with Downloadable Calculator)

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How to Calculate NPV


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Three Parts:

Edited 11 weeks ago

NPV Calculator

Calculating NPV

Using the NPV Equation

In the business world, Net present value (or NPV) is one of the most helpful
tools available for financial decision making. Usually, NPV is used to estimate
whether a certain purchase or investment is worth more in the long run than
simply investing an equivalent amount of money in the bank. While it is often
used in the world of corporate finance, it can also be used for everyday
t

purposes. Generally, NPV can be calculated as the sum of (P / (1 + i) ) - C for


all positive integer values up to t where t is your number of time periods, P
is your cash inflow, C is your initial investment, and i is your discount rate. For
a step-by-step breakdown, get started with Step 1 below!
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NPV Calculator

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Part 1 of 2: Calculating NPV

Determine your initial investment. In the world of business, purchases and


investments are often made with the goal of earning money in the long run. For

instance, a construction company might buy a bulldozer so that it can take on bigger
projects and make more money over time than it would have if it had saved the money
and only taken small projects. These sorts of investments usually have a single initial
cost to begin to find your investment's NPV, identify this cost.
As an example, let's imagine that you operate a small lemonade stand. You are
considering buying an electric juicer for your business which will save you time
and effort compared to juicing the lemons by hand. If the juicer costs $100, $100
is your initial investment. Over time, this initial investment will hopefully allow
you to make more money than you would have without making it. In the next

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few steps, you'll use your $100 initial investment value to calculate NPV and
determine whether it's "worth it" to buy the juicer.
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Determine a time period to analyze. As noted above, businesses and individuals


make investments with the goal of making money in the long run. For instance, if a

sneaker factory buys a shoe-making machine, the "goal" of this purchase is for the
machine to generate enough money to pay for itself and turn a profit before it breaks or
wears out. To determine the NPV for your investment, you'll need to specify a time
period during which you're trying to determine whether the investment will pay for itself.
This time period may be measured in any unit of time, but for most serious financial
calculations, years are the unit used.
In our lemonade stand example, let's say that we've researched the juicer we
intend to buy online. According to most reviews, the juicer works great, but
usually breaks after about 3 years. In this case, we'll use 3 years as the time
period in our NPV calculation to determine whether the juicer will pay for itself
before it's likely to break.

Estimate your cash inflow for each time period. Next, you'll need to estimate
how much money your investment will make you during each time period for which

it's earning you money. These amounts (or "cash inflows") can be specific, known
values, or they can be estimates. In the latter case, companies and financial firms
sometimes devote a great deal of time and effort to getting an accurate estimate, hiring
industry experts, analysts, and so on.
Let's continue with our lemonade stand example. Based on your past
performance and your best future estimates, you assume that implementing the
$100 juicer will bring in an extra $50 the first year, $40 the second year, and $30
the third year by reducing the time your employees need to spend juicing (and
thus saving you money on wages) In this case, your expected cash inflows are:
$50 in year 1, $40 in year 2, and $30 in year 3.

Determine the appropriate discount rate. In general, a given amount of money is


worth more now than it is in the future. This is because the money you have today

can be invested in an interest-earning account and gain value over time. In other words,
it's better to have $10 today than $10 one year in the future because you can invest your
$10 today and have more than $10 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
investment you're analyzing. This is called your "discount rate" and is expressed as a
decimal, rather than a percent.
In corporate finance, a firm's weighted-average cost of capital is often used to
determine the discount rate. In simpler situations, you can usually just use the
return rate on a savings account, stock investment, etc. that you might put your
money in instead of making the investment you're analyzing.
In our lemonade stand example, let's say that if you don't purchase the juicer,
you'll invest the money in the stock market, where you feel confident that you

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can earn 4% annually on your money. In this case, 0.04 (4% expressed as a
decimal) is the discount rate we'll use in our calculation.

Discount your cash inflows. Next, we'll weight the value of our cash inflows for
each time period we're analyzing against the amount of money we'll make from our

alternate investment in the same period. This is called "discounting" the cash flows and
t

is done using the simple formula P / (1 + i) , where P is the amount of the cash flow, i is
the discount rate, and t represents time. We don't need to worry about our initial
investment yet we'll use this in the next step.
In our lemonade example, we're analyzing three years, so we'll need to use our
formula three times. Calculate your yearly discounted cash flows as follows:
1

Year One: 50 / (1 + 0.04) = 50 / (1 .04) = $48.08


2

Year Two: 40 / (1 +0.04) = 40 / 1.082 = $36.98


3

Year Three: 30 / (1 +0.04) = 30 / 1.125 = $26.67

Sum your discounted cash flows and subtract your initial investment. Finally,
to get the total NPV for the project, purchase, or investment you're analyzing, you'll

need to add up all of your discounted cash flows and subtract your initial investment.
The answer you get for this calculation represents your NPV the net amount of money
that your investment will make compared to the alternate investment that gave you the
discount rate. In other words, if this number is positive, you'll make more money than if
you had spent it on an alternative investment, and if it's negative, you'll make less
money. Remember, however, that the accuracy of your calculation hinges on how
accurate your estimates for your future cash inflows and your discount rate were.
For our lemonade stand example, the final projected NPV value of the juicer
would be:
48.08 + 36.98 + 26.67 - 100 = $11.73

Determine whether or not to make the investment. In general, if the NPV for
your investment is a positive number, then your investment will be more profitable

than putting the money in your alternate investment and you should accept it. If the NPV
is negative, your money is better invested elsewhere, and your proposed investment
should be rejected. Note that these are generalities in the real world, much more
usually goes into the process of determining whether a certain investment is a wise idea.
In the lemonade stand example, the NPV is $11.71. Since this is positive, we'll
probably decide to buy the juicer.
Note that this doesn't mean that the electric juicer only made you $11.71. In fact,
this means that the juicer made you the required return rate of 4% annually, plus
an additional $11.71 on top of that. In other words, it's $11.71 more profitable
than your alternate investment.

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Part 2 of 2: Using the NPV Equation

Compare investment opportunities by their NPV. Finding the NPVs for multiple
investment opportunities allows you to easily compare your investments to

determine which are more valuable than others. In general, the investment with the
highest NPV is the most valuable because its eventual payout is worth the most in
present dollars. Because of this, you'll usually want to pursue the investments with the
highest NPVs first (assuming you don't have enough resources to pursue every
investment with a positive NPV).
For instance, let's say that we have three investment opportunities. One has an
NPV of $150, one has an NPV of $45, and one has an NPV of -$10. In this
situation, we'd pursue the $150 investment first because it has the greatest
NPV. If we have enough resources, we'd pursue the $45 investment second
because it's less valuable. We wouldn't pursue the -$10 investment at all
because, with a negative NPV, it will make you less money than investing in an
alternative with a similar level of risk.

Use PV = FV / (1+i) to find present and future values. Using a slightly modified
form of the standard NPV formula, it's possible to quickly determine how much a

present sum of money will be worth in the future (or how much a future sum of money is
t

worth in the present). Simply use the formula PV = FV / (1+i) , where i is your discount
rate, t the number of time periods being analyzed, FV is the future money value, and PV
is the present value. If you know i, t, and either FV or PV, it's relatively simple to solve for
the final variable.
For instance, let's say we want to know how much $1,000 will be worth in five
years. If we know that, at bare minimum, we can get a return rate of 2% on this
money, we'll use 0.02 for i, 5 for t, and 1,000 for PV and solve for FV as follows:
1,000 = FV / (1+0.02)
1,000 = FV / (1.02)

1,000 = FV / 1.104
1,000 1.104 = FV = $1,104.

Use the Internal Rate of Return. The Internal Rate of Return (or IRR) is the
discount rate that gives you an NPV of zero. In other words, it's the discount rate at

which an alternate investment is exactly as valuable as the one you're analyzing. This
can be another useful tool for judging which investments are the wisest. In general,
investments with high IRRs are more valuable than ones with low IRRs because this
means that the rate of return on an alternate investment would need to be higher to
generate the same amount of value.
For example, if we have one possible investment with an IRR of 5% (i = 0.05)
and one with an IRR of %10 (i = 0.10), we should take the %10 investment
because an alternate investment would have to have a higher return rate to be
as valuable in other words, it's the more profitable investment.
You can find your investment's IRR with the NPV equation by solving for i when
NPV = 0, but this requires complex math if you're analyzing more than one time
period (t >1). An easier solution is to use a simple online IRR calculator, like this
one.

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Research valuation methods for more accurate NPVs. As noted above, the
accuracy of any NPV calculation basically depends on the accuracy of the values

you use for your discount rate and your future cash inflows. If your discount rate is close
to the actual return rate you can get on your money for an alternate investment of similar
risk and your future cash inflows are close to the amounts of money you'll actually make
from your investment, your NPV calculation will be right on the money. To get your
estimates for these values as close to their corresponding real-world values as possible,
you may want to take a look at corporate valuation techniques. Because large
corporations often have to make enormous multi-million dollar investments, the methods
they use to determine whether the investments are sound or not can be quite
sophisticated.
A variety of financial resources are available online that can introduce the
somewhat tricky fundamentals of corporate valuation to novices. For instance,
this short beginner's guide is a great place to start.
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Tips
Always remember that there may be other, non-financial factors (such
as environmental or social concerns) to consider when making any
investment decision.
NPV can also be calculated using a financial calculator or a set of NPV
tables, which are useful if you don't have a calculator to perform the
cash flow discounts.
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Warnings
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Sources and Citations


http://www.investopedia.com/terms/n/npv.asp
http://www.investopedia.com/terms/c/cashflow.asp
http://news.morningstar.com/classroom2/course.asp?docId=145101&
page=2&CN=COM
http://www.mathsisfun.com/money/net-present-value.html
http://finance.thinkanddone.com/npv.html
http://www.investopedia.com/articles/financial-theory/11/corporateproject-valuation-methods.asp
http://www.datadynamica.com/irr.asp

Article Info

Categories: Accounting and Regulations


Recent edits by: Allie, Pafsilipoclub, Oliver
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