In the business world, Net present value (aka NPV) is one of the most helpful tools out there for making financial decisions. Usually, the NPV is used to estimate whether a purchase or investment is more valuable in the long run than simply investing some money in a bank. Although often used in the corporate finance world, it can also be used for everyday purposes. In general, NPV can be calculated as summation (P / (1 + i)t) - C for every positive integer up to t where t is the length of the time period, P is your cash inflow, C is your initial investment, and I is your percent discount. For a step-by-step breakdown, start with Step 1 below!
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Method 1 of 2: Calculating NPV
Step 1. Determine your initial investment
In the business world, purchases and investments are often made with the aim of earning money in the long run. For example, a construction company might buy a bulldozer so that it can take on bigger projects and make more money over time than if it saved money and only took on smaller projects. This kind of investment usually has a single initial cost - to start finding the NPV of your investment, identify this cost.
For example, let's imagine that you run a small lemonade stand. You are considering purchasing an electric juicer for your business which will save you time and effort compared to squeezing 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 made if you hadn't invested. In the next few steps, you'll use the value of your initial $100 investment to calculate your NPV and determine if it's "worth it" to buy a juicer.
Step 2. Determine the timeframe for analysis
As mentioned above, businesses and individuals make investments with the aim of making money in the long term. For example, if a shoe manufacturer purchases a shoe-making machine, the "purpose" of this purchase is for the machine to make enough money to cover its costs and make a profit before it breaks down or wears out. To determine the NPV for your investment, you must determine the period of time during which you are trying to determine whether the investment will break even. This time period can be measured in any unit of time, but for the most serious financial calculations, the year is the unit used.
In our lemonade stand example, let's say we've researched a juicer that we want to buy online. According to most reviews, the juicer works fine, but usually breaks down after about 3 years. In this case, we will use 3 years as the period of time in our NPV calculation to determine whether the juicer will recoup its purchase costs before the time it is likely to fail.
Step 3. Estimate the cash inflows for each time period
Next, you must estimate how much money your investment will bring to yourself each period of time it is generated. These amounts (or "cash inflows") can be known specific values, or they can be estimates. In the latter case, financial firms and firms sometimes devote a great deal of time and effort to obtaining accurate forecasts by hiring industry experts, analysts, and so on.
Let's continue with our lemonade stand example. Based on your past performance and your best estimate of the future, you assume that using a $100 juicer will bring in an additional $50 in year one, $40 in year two, and $30 in year three by reducing the time your employees need to spend juicing (thus saving money). for salary). In this case, your expected cash inflows are: '$50 in year 1, $40 in year 2, and $30 in year 3'
Step 4. Determine the appropriate interest rate
In general, the amount of money given is more valuable now than in the future. This is because the money you currently have can be invested in an interest-earning account and gain value from it over time. In other words, it's better to have $10 today than $10 a year in the future because you can invest $10 today and have more than $10 in a year. For the calculation of NPV, you need to know the interest rate of the account or investment opportunity with the same level as the investment risk you are analyzing. This is called your "interest rate" and is expressed as a decimal, not a percent.
- In corporate finance, a company's weighted average cost of capital is often used to determine interest rates. In the simplest case, you can usually simply use the rate of return (ROR) from savings accounts, stock investments, etc.
- In our lemonade stand example, suppose that if you don't buy a juicer, you invest money in the stock market, where you feel confident that you can earn 4% per year on your money. In this case, 0, 04 (4% expressed as a decimal) is the interest rate we will use in our calculations.
Step 5. Interest your cash flow
Next, we will weigh the value of our cash inflows for each time period that we analyze against the amount of money we would make from our alternative investments in the same period. This is called "interesting" cash flows and is done using a simple formula P / (1 + i)t , where P is the amount of cash flows, i is the interest rate, and t is time. We don't have to worry about our initial investment yet - we'll use this in the next step.
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In our lemonade example, we analyzed three years, so we have to use our formula three times. Calculate the annual cash flow at interest as follows:
- First Year: 50 / (1 + 0.04)1 = 50 / (1 0, 04) = $48, 08
- Second Year: 40 / (1 0.04)2 = 40 / 1, 082 = $36, 98
- Third Year: 30 / (1 0.04) 3 = 30 / 1.125 = $ 26, 67
Step 6. Add up your cash flow interest and subtract your initial investment
Finally, to get the total NPV for the project, purchase, or investment you are analyzing, you must add up all of your interest-bearing cash flows and subtract your initial investment. The answer you get for this calculation is your NPV - that is, the net amount of money your investment will make compared to the alternative investment that gives you the interest rate. In other words, if this amount is positive, you will make more money than if you had used it on alternative investments, and if the result is negative, you will make less money. Remember, however, that the accuracy of your calculations depends on how accurate your estimates of your future cash inflows and interest rates are.
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For our lemonade stand example, the final projected NPV value of the juicer would be:
48, 08 + 36, 98 + 26, 67 - 100 = $ 11, 73
Step 7. Decide whether you will invest or not
In general, if the NPV for your investment is a positive number, then your investment will be more profitable than putting money in your alternative investment and you should accept it. If the NPV is negative, your money is better invested elsewhere, and your investment proposal should be rejected. Note that these are generalizations - the reality on the ground, far more often goes into the process of determining whether a particular investment is a wise idea.
- In the lemonade stand example, the NPV is $11.73. Since this is a positive, we might decide to buy a juicer.
- Note that this doesn't mean that the electric juicer only earns you $11.73. In fact, it does mean that the juicer earns you the required 4% annual rate of return, plus an additional $11.73 on top of that. In other words, it's $11.73 more profitable than alternative investments.
Method 2 of 2: Using the NPV. Equation
Step 1. Compare the investment opportunity with its NPV
Finding the NPV 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 the largest in current dollars. Because of this, you'll generally want to pursue the investment with the highest NPV in the past (assuming you don't have sufficient resources to pursue every investment with a positive NPV).
For example, suppose we have three investment opportunities. One has an NPV of $150, someone has an NPV of $45, and one has an NPV of -$10. In this situation, we will chase the $150 investment first because it has the largest NPV. If we have sufficient resources, we will chase the next $45 investment because it is less valuable. We wouldn't go after an investment that was -$10 at all because, with a negative NPV, it would make less money than investing in an alternative with the same level of risk
Step 2. Use PV = FV / (1 + i)t to find present and future values.
Using a modified form of the standard NPV formula, it is possible to quickly determine how much a current amount of money will be worth in the future (or what a future amount of money will be today). It is enough to use the formula PV = FV / (1 + i)t, where i is your interest rate, t is the number of time periods analyzed, FV is the future value of money, and PV is the current value. If you know i, t, FV or PV, solving the final variable is relatively simple.
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For example, let's say we want to know how much $1000 will be worth in five years. If we knew that, at the very least, we could earn a 2% rate of return on this money, we would use 0.02 for i, 5 for t, and 1,000 for PV and solve for FV as follows:
- 1000 = FV / (1 + 0.02)5
- 1,000 = FV / (1, 02)5
- 1000 = FV / 1.104
- 1,000 × 1, 104 = FV = $ 1104.
Step 3. Find a scoring method for a more accurate NPV
As noted above, the accuracy of any NPV calculation depends essentially on the accuracy of the values you use for your interest rate and your future cash flows. If your interest rate is close to the actual rate you could earn on your money for an alternative investment of equal risk and your future cash flows are close to the amount of money you actually made on your investment, your NPV calculation is correct. To get your estimates for these values as close as possible to their real-world values, you may want to pay attention to company valuation techniques. Because large corporations often have to make large investments of millions of dollars, the methods they use to determine whether or not an investment is sound can be quite sophisticated.
Tips
- Always keep in mind that there may be other non-financial factors (such as environmental or social interests) to consider when making any investment decision.
- NPV can also be calculated using a financial calculator or a set of NPV tables, which is useful if you don't have a calculator for cash flow interest.
