Making Business Decisions Using Net Present Value

by Craig Anthony

1 min read

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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