Sayali Bedekar Patil
Oct 7, 2018

A net present value calculation, in simple words, is nothing but a figure that tells if an investment is profitable or not, in 'return on investment' terms. Here we will tell you how to calculate net present value (NPV) and interpret it.

Before investing a single cent into any venture, you must know what it is that you will be getting out of every dollar invested, and knowing how to calculate net present value of the venture will give you those exact analysis figures.

Ideally, the value of any investment venture should be positive, for positive values indicate your investment growth. They back your investment decisions soundly and prudently. To understand this concept better, understand the underlying theory of this financial term.

It is nothing but the times series of cash flows emanating during the entire investment period, expressed in present value figures. The value takes into account both positive and negative monetary flows, i.e., it takes into account both the investments made and the incomes generated.

Using the principles of the concept of 'time value of money', all future income cash flows are discounted to present period using a proper discount rate that considers all financial parameters like risk of investment, inflation rate, etc. Used in financial, economic decision making, net present value (NPV) is a sign for an investment being profitable or not.

If it is positive (greater than 0), the investment venture is accepted, and if it is negative (less than 0), the project is rejected. Positive NPV indicates that the concerned project has actually added some value to the firm, and a negative NPV suggests that the firm's value has eroded because of this wrong investment decision.

NPV is always a better investment appraisal method when compared to other methods like payback period and accounting rate of return (ARR), because it uses the time value of money concept that the others don't.

However, the effectivity of calculating NPV is entirely dependent on which discount rate is chosen to discount the cash flows. Both artificially high and incorrectly low discount rates yield the net present value as an inefficient measure that leads to erroneous decision making.

Hence, in order to correctly calculate values, one needs to research well on the discount rate to be used first. Also, as NPV does not give absolute gain or loss pictures of the project, it is always better to supplement the information provided by it with other measures like the internal rate of return (IRR).

where,

t = time period of cash flow

i = discount rate (as per market risk standards)

Here is a simple step by step breakdown of how to calculate this value

☛ The first step is to find out the initial outlay required to be invested by you into the concerned project. All calculations will be relative to the investment required and so it is extremely necessary that you come up with an accurate figure, inclusive of all relevant costs.

☛ The first step is to find out the initial outlay required to be invested by you into the concerned project. All calculations will be relative to the investment required and so it is extremely necessary that you come up with an accurate figure, inclusive of all relevant costs.

☛ The next step is to project or forecast the periodic cash inflows throughout the active project. As we are specifically dealing with cash flows, we won't consider the non-cask expenses like depreciation per se, but as these figures are needed to calculate taxation, one has to deduct them first to get the profit before tax and add them back post taxation.

Another thing to highlight are the terminal cash flows at the end of the project life. In the last period of the project, several additional cash flows like salvage value of machinery come into picture. These and other terminal cash flows must be included in the last analysis period. Once all net cash flows are ready for analysis, move on to the next step.

☛ Once everything for the analysis is ready, you need to get yourself a proper discount rate. You entire NPV analysis will be grossly erroneous if this one most important factor is not calculated properly. The discount rate has to be in line with the market discount rate on projects of similar risk and must be prudently in line with future expectations.

☛ Now all that is left is to discount all the future period cash flows to current period using the discount rate. One can either use the present value tables to look up the cash flow values or one can even do the calculations on a calculator.

Once all the future cash flows are calculated, you need to total them all and net them against the initial cash outlay. One thing to note is that the current period cash outlay is already in the present period and does not require any discounting.

☛ After netting, the figure you have, is your NPV. If this value is positive, you have your investment worthy project in hand and if not, you will be wise to drop it.

Once you calculate net present values of different projects, you can compare the same and choose the ones that give the highest value addition. It is a good comparison tool and also helps in crucial capital budgeting when the choice is between two projects with different initial outlays and time periods.

Before you blindly calculate and use the net present value method, please update yourself on its benefits and pitfalls, especially in comparison to other such methods first.