Net Present Value (NPV) is the value of all future cash flows (positive and negative) over the entire life of an investment discounted to the present. Here’s a quick overview on how to use this formula correctly.

What is NPV?

The Net Present Value (NPV) is a formula used to estimate future revenue generated by a project relative to the initial investment. It is used by investors to determine the venture that is likely to generate the most profit.

If the investment has a positive NPV, it is a worthwhile investment because the future cash flows from the project exceed the income from alternative investments. Accountants calculate NPV by estimating the future cash flows for each accounting period to determine the discount rate.

The required rate of return

The expected rate of return or discount rate is a factor used to account for the time value of money. The rationale is that money available today is more valuable than future earnings because it can be invested to generate income. Thus, when calculating the NPV, accountants consider the lost income due to the delay.

The formula for NPV

Calculating NPV involves deducting the initial capital investment from the expected returns. Some projects can return the investment within one year, while others take several years to break even.

NPV = cash flow/(1+i)t – the initial investment

where:

i= expected return or discount rate

t= time in terms of accounting periods

If the project is long-term and will generate cash flow for several years, the formula for NPV is:

NPV = ∑_(t=0)^n▒〖 Rt/(1+i)〗 t

where:

Rt= net cash flow during the period t

i= discount rate or returns that the investor could earn in alternative investments

t= number of accounting periods

An example of NPV calculation

A project with a capital investment of $900 provides revenues of $300, $500 and $700 over three years.
Assume the expected return rate is 10%. The NPV for the project will be:

NPV= (300/(1+0.10)1) + (500/(1+0.10)2) + (700/(1+0.10)3) -1200 = $312

Comparing investments

NPV can be used to compare the expected returns of different ventures to determine the best investment option. Investors will often select the project with the highest NPV.

For example, project A requires a capital investment of $25,000 and delivers returns of $10,000, $20,000, and $22,000 in the first, second and third accounting period. The targeted rate of return is 10%. The NPV for the project is:

NPV= 10,000/(1+.10) + 20,000/(1+.10)2 + 22,000/(1+.10)3 – 25,000 = $17,149

Another project B requires $25,000 in capital and generates $25,000 for two accounting periods. The targeted discount rate is 10%.

NPV = 25,000/(1+.10) + 25,000/(1 +.10)2 -25,000 = $18,388

Decision

Project A generates more income than project B. However, project B has a higher NPV because the investment makes returns within two accounting periods instead of three. The investors select project B.

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