# Making Business Decisions Using Net Present Value

Net present value is a method used in finance and business to determine if a particular project is worth pursuing. Learn more about NPV and how it is calculated, and check out an example comparison of various projects using net preset value.

## What is Net Present Value?

NPV is a quantitative measure that takes into account a projects cash inflows, cash outflows, and the time value of money to determine if undertaking a business project is a good idea. To put it another way, NPV is a capital budgeting tool used to analyze the profitability of a project or projected investment.

## Net Present Value Formula

The formula for NPV takes into account four variables:

• C(t) = net cash flow during period t
• C(0) = total initial outlay
• r = the discount rate
• t = number of time periods

The formula is:

NPV = the sum of: (C(t) / (1 + r) ^ t) – C(0)

## Example Net Present Value Calculation

As an example, assume a project is expected to last for five years. The expected cash inflows from the project for each year are estimated at:

• Year 1: \$5,000
• Year 2: \$7,000
• Year 3: \$10,000
• Year 4: \$12,000
• Year 5: \$15,000

The assumed discount rate is 7%, and the initial cost of the project right now is \$25,000. The discounted cash flows for each year are:

• Year 1: \$5,000 / (1 + 7%) ^ 1 = \$4,672.90
• Year 2: \$7,000 / (1 + 7%) ^ 2 = \$6,114.07
• Year 3: \$10,000 / (1 + 7%) ^ 3 = \$8,162.98
• Year 4: \$12,000 / (1 + 7%) ^ 4 = \$9,154.74
• Year 5: \$15,000 / (1 + 7%) ^ 5 = \$10,694.79

The sum of these cash flows equals \$38,799.48. Thus the NPV for this project is:

NPV = \$38,799.48 – \$25,000 = \$13,799.48

## Comparing Business Projects With Net Present Value

Projects should be accepted and pursued if the NPV is greater than \$0. A positive NPV means that the earnings from the project exceed the initial costs of the project. In other words, a positive NPV implies profitability. A negative NPV indicates that the project will not produce sufficient cash flow to cover the initial capital outlay. It loses money and should be avoided.

Assume a manager conducts an NPV analysis on five projects and concludes the following:

Project 1 NPV = \$10,000Project 2 NPV = \$3,300Project 3 NPV = (\$2,500)Project 4 NPV = \$0Project 5 NPV = \$4,000

In this example, it is clear that projects 1, 2, and 5 are profitable. The highest NPV project should be pursued first. However, if the company has enough capital in its budget to pursue all three profitable projects, it should. Projects 3 and 4 should not be pursued.

When conducting NPV analysis, it is always wise to do the analysis using multiple discount rates, as this assumption can easily alter net present value.

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