Net Present Value

Net Present Value (NPV) is the difference between the present value of cash inflows and the present
value of cash outflows over a period of time. NPV is used in capital budgeting to analyze the profitability
of a projected investment or project.

The following is the formula for calculating NPV:

Formula used to calculate the Net Present Value (NPV)

Where

Ct = net cash inflow during the period t

Co = total initial investment costs

r = discount rate, and

t = number of time periods

A positive net present value indicates that the projected earnings generated by a project or investment
(in present dollars) exceeds the anticipated costs (also in present dollars). Generally, an investment with
a positive NPV will be a profitable one and one with a negative NPV will result in a net loss. This concept
is the basis for the Net Present Value Rule, which dictates that the only investments that should be
made are those with positive NPV values.

When the investment in question is an acquisition or a merger, one might also use the Discounted Cash
Flow (DCF) metric.

Apart from the formula itself, net present value can often be calculated using tables, spreadsheets such
as Microsoft Excel or Investopedia’s own NPV calculator.

Decision Rule
In case of standalone projects, accept a project only if its NPV is positive, reject it if its NPV is
negative and stay indifferent between accepting or rejecting if NPV is zero.

In case of mutually exclusive projects (i.e. competing projects), accept the project with higher NPV.
 Example 1: Even Cash Inflows: Calculate the net present value of a project which requires an initial
investment of $243,000 and it is expected to generate a cash inflow of $50,000 each month for 12
months. Assume that the salvage value of the project is zero. The target rate of return is 12% per
annum.
Solution
We have,
Initial Investment = $243,000
Net Cash Inflow per Period = $50,000
Number of Periods = 12
Discount Rate per Period = 12% ÷ 12 = 1%
Net Present Value
= $50,000 × (1 − (1 + 1%)^-12) ÷ 1% − $243,000
= $50,000 × (1 − 1.01^-12) ÷ 0.01 − $243,000
≈ $50,000 × (1 − 0.887449) ÷ 0.01 − $243,000
≈ $50,000 × 0.112551 ÷ 0.01 − $243,000
≈ $50,000 × 11.2551 − $243,000
≈ $562,754 − $243,000
≈ $319,754

Example 2: Uneven Cash Inflows: An initial investment of $8,320 thousand on plant and
machinery is expected to generate cash inflows of $3,411 thousand, $4,070 thousand, $5,824
thousand and $2,065 thousand at the end of first, second, third and fourth year respectively. At the
end of the fourth year, the machinery will be sold for $900 thousand. Calculate the net present value
of the investment if the discount rate is 18%. Round your answer to nearest thousand dollars.
Solution
PV Factors:
Year 1 = 1 ÷ (1 + 18%)^1 ≈ 0.8475
Year 2 = 1 ÷ (1 + 18%)^2 ≈ 0.7182
Year 3 = 1 ÷ (1 + 18%)^3 ≈ 0.6086
Year 4 = 1 ÷ (1 + 18%)^4 ≈ 0.5158