How to calculate net present value (NPV)

One way to decide if an investment or project is worthwhile is to calculate something called NPV.
This article will show you how to calculate it's value. And as an instructor, I'll walk you through every
step in terms you'll easily understand.
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Instructions

 **What is NPV?**
Before I show you how to calculate the net present value or NPV, let me briefly explain what it is.
Simply put, it's a way to decide whether or not to invest in a project by looking at the projected cash
inflows and outflows.
 2
**How NPV helps you decide**
Now that you understand what NPV is, let me tell you how you use it to decide if a project is a go or
not. Simple:
a) If the value of NPV is greater than 0, then the project is a go! In other words, it's profitable and
worth the risk.
b) If the value of NPV is less than 0, then the project isn't worth the risk and is a no-go. In other
words, you'll pass on it.
So NPV takes risk and reward into consideration, which is why we use it in the world of corporate
finance and capital budgeting.
 3
**Example**
In order for us to calculate NPV, let's use the following example.
Suppose we'd like to make 10% profit on a 3 year project that will initially cost us $10,000.
a) In the first year, we expect to make $3000
b) In the second year, we expect to make $4300
c) In the third year, we expect to make $5800
 4
**Calculation step 1**
Right now, the project is going to cost us $10,000. So we won't be making any money until at least a
year from now. What we need to do is calculate how much each of those future profit amounts will
be worth right here, today.
This means we need to calculate the present value of each of those 3 cash flows we'll be getting
over the next three years. In other words, ask yourself:
a) How much is that $3000 one year from now worth today?
b) How much is that $4300 two years from now worth today?
c) How much is that 5800 worth three years from now worth today?
The answers to each of these three questions is the present value for that particular cash inflow.
 5
**Calculation step 2**
In my example, I said I'd like to make a 10% profit. This is important because it's the bare minimum
we'll need to make in order to say yes to this project. In corporate finance, we call this rate our
required rate of return (ROR).
To get our present values, we use this ROR!
In other words, we ask ourselves:
a) Earning 10%, $3000 one year from today would be worth how much right now?
b) Earning 10%, $4300 two years from today would be worth how much right now?
c) Earning 10%, $5800 three years from today would be worth how much right now?
 6

Present value table

**Calculation step 3**

Let's assume you're using present value tables to get your answers.
a) You'll go over to 10% and down to 1 in the time period column to get your interest factor. It'll be
something like 0.9091. Multiply this factor by the $3000 we'll be getting in the first year, and it gives
us a present value of $2727.27.
b) Do the same thing for the $4300 we'll be getting in the second year. This time, you'll go over to
10% and down to 2 in the time period column to get your interest factor. That'll be 0.8264. Multiply
this by the $4300 to get a present value of $3,553.72
c) Do the same thing for the $5800 we'll be getting in the third year. This time, you'll go over to 10%
and down to 3 in the time period column to get your interest factor. That'll be 0.7513. Multiply this by
the $5800 to get a present value of $4,357.63
 7
**Calculation step 4**
Our next step is to add up all those present values we just calculated in step 6.
Adding $2,727.27 + $3,553.72 + $4,357.63 gives us $10,638.62.
 8
**Final step**
The last thing we need to do is subtract our original investment in the project from the result in step
7.
Doing this gives us $10,638.62 - $10,000 or $638.62. This is our NPV!
So is this project a go? Well remember what I said at the very beginning. If NPV is bigger than 0,
then it's a go. Well $638.62 is clearly larger than 0 which means the project is worth it and is a go!
 9

A financial calculator

**Using a financial calculator to get your answer**

In my example, I used present value tables to calculate NPV. You can also do it using a financial
calculator.
a) To get the present value of that $3000 we'll be getting in the first year, you'll enter 3000 as your
fugure value (FV). Why? Because that money won't be received until a year from now.
Then you'll enter 1 for the time period (NPER or N key) on the calculator. This means 1 year from
now. Next, you'll enter 10% by using the %i key for your rate because that's what you'd like to earn.
You'll now compute the present value (PV)by pressing some combination of keys on your calculator.
Which ones that'll be will vary. For instance, on mine I press CPT for compute and PV for present
value. Lastly, you'll store that value in memory. This is so you can add all those present values from
the other years together.
TIP: On some calculators, you enter the rate as 10%. On others, you type .10. Be sure you enter it
correctly or your answer will be wrong!
Doing this calculation will give you the same answers as we got in step 6.
b) Do the same thing for the $4300 we'll be getting in the second year. But this time, you'll enter 2 for
your time period (N or NPER key) and 4300 as your future value (FV).
Why 2 for the time period? Because you won't get that money until 2 years from now. Now compute
your present value and add it to your previous one in part (a).
c) Do the same thing for the $5800 we'll be getting in the third year. But this time, you'll enter 3 for
your time period (N or NPER key) and 5800 as your future value (FV).
Why 3 for the time period? Because you won't get that money until 3 years from now. Now compute
your present value and add it to your previous one in part (b).
You've calculated the present values of those 3 cash inflows you've gotten from the project or
investment and have added them all together. The final step is to subtract the original investment,
which is $10,000 in my example.
So adding all the present values together will give you the same answer as in step 7. And
subtracting the original $10,000 investment will give you the same result in step 8.
So your NPV will be $638.62 in both cases!

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net present value (NPV)

Definition

Difference between the present value (PV) of the future cash flows from an investment
and the amount of investment. Present value of the expected cash flows is computed
by discounting them at the required rate of return (also called minimum rate of return).
For example, an investment of $1,000 today at 10 percent will yield $1,100 at the end
of the year; therefore, the present value of $1,100 at the desired rate of return (10
percent) is $1,000. The amount of investment ($1,000 in this example) is deducted
from this figure to arrive at NPV which here is zero ($1,000-$1,000). A zero NPV means
the project repays original investment plus the required rate of return. A positive NPV
means a better return, and a negative NPV means a worse return, than the return from
zero NPV. It is one of the two discounted cash flow (DCF) techniques (the other is
internal rate of return) used in comparative appraisal of investment proposals where
the flow of income varies over time.

NPV (net present value)

A present value is the value now of a stream of future cash flows, negative or
positive. The value of each cash flow needs to be adjusted for risk and the
time value of money.
A net present value (NPV) includes all cash flows including initial cash flows
such as the cost of purchasing an asset, whereas a present value does not.
The simple present value is useful where the negative cash flow is an initial
one-off, as when buying a security (see DCF valuation for more detail)
A discount rate needs to be used to adjust for risk and time value, and it is
applied like this:
NPV = CF0 + CF1/(1+r) + CF2/(1+r)2 + CF3/(1+r)3 ...

where CF 1 is the cash flow the investor receives in the first year, CF2 the
cash flow the investor receives in the second year etc.
and r is the discount rate.
The series will usually end in a terminal value, which is a rough estimate of
the value at that point. It is usual for this to be sufficiently far in the future to
have only a minor effect on the NPV, so a rough estimate,usually based on a
valuation ratio, is acceptable.
Periods other than an year could be used, but the discount rate needs to be
adjusted. Assuming we start from an annual discount rate then to adjust to
another period we would use, to get a rate i, given annual rate r, for a period
x, where x is a fraction (e.g., six months = 0.5) or a multiple of the number
of years:
i + 1 = (r + 1)x

To use discount rates that vary over time (so r1 is the rate in the first period,
r2 = rate in the second period etc.) we would have to resort to a more basic
form of the calculation:
NPV = CF0 + CF1/(1+r1) + CF2/((1+r1) ×(1+r2)) + CF3/((1+r1) ×(1+r2) ×(1+r3)) ...

This would be tedious to calculate by hand but is fairly easy to implement in

a spreadsheet.

Weaknesses of NPV
The NPV calculation is very sensitive to the discount rate: a small change in
the discount rates causes a large change in the NPV. As the estimate of the
appropriate discount rate is uncertain, this makes NPV numbers very
uncertain (see CAPM and WACC).
An NPV also often relies on uncertain forecasts of future cash flows. How
much of a problem this is obviously depends on how uncertain the forecasts
are. One solution to both problems is to calculate a range of NPV numbers
using different discount rates and forecasts, so that one can generate, for
example, best, worst and median case NPV numbers, or even a probability
distribution for the NPV (possibly using something like a Monte-Carlo
approach).