What Is NPV? (With Advantages, Formulas And Examples)

By Indeed Editorial Team

Published 11 May 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Net present value (NPV) is critical for capital budgets and allows investors to determine the returns of current or future investments. It enables businesses and investors to make informed decisions by accounting for all risk factors involved in their investment choices. Understanding the net present value calculation and its advantages can help businesses evaluate their future projects. In this article, we discuss what NPV is, determine the formula to calculate it, understand its advantages and share tips to ease the process along with examples to refer to while calculating it.

What is NPV?

Learning the answer to "What is NPV?" can help businesses understand cash flows and make more informed decisions. Net present value (NPV) helps financial analysts, investors, managers and other business stakeholders calculate the return on investment (ROI) on current investment. It is the difference between the present value of cash inflow and the present value of cash outflow over a given period. Financial analysts use the method to evaluate projects involving cash flow. It allows business stakeholders to determine their risks and future stream of payments before making an investment decision or beginning a new venture.

Related: What Is Asset Management? (With Career Options)

Formula to calculate the net present value

Before you calculate the net present value, it is essential to identify the period and the number of investment channels. Additionally, understand the interest rate for the calculation. If there is only one cash flow that gets paid within a year, use the following formula to calculate the net present value:

NPV = ∑ (Cashflow/(1+i)^t)-Initial Investment

Here, i represents the interest rate or discount rate and t represents the period. When there are multiple cash flows and a longer period, it is essential to calculate the NPV for each cash flow for the defined period. The result from the summation of the individual values is the necessary NPV. In simpler terms, i is the present expected cash flow subtracted by the present value of invested cash.

Where is NPV used?

NPV helps financial analysts make critical business decisions. Before investing, it helps analysts understand the risk associated with a project. Since NPV considers the time value of money, it helps understand the future cash flow in the present time. Companies use NPV in several situations, including:

  • purchase of equipment

  • mergers and acquisitions

  • investment in a new project

  • expansion of business

  • capital budgeting

  • financial modelling

  • cost reduction program

If the NPV value is positive, then the investment is considered profitable. A negative NPV value gradually uses cash from a business without generating the necessary return on investment. A higher NPV value indicates greater benefits to a company.

Related: What Is Financial Modelling? (With Benefits And Types)

Tips to remember while using NPV value

It is essential to understand the implications of net present value before making a business decision. Several factors affect the net present value and it is crucial to remember them while calculating it. Here are some tips to remember while using or calculating it:

Assume the appropriate discount or interest rate

It is crucial to determine the appropriate interest or discount rate to improve the accuracy of NPV. A higher rate of return may result in a false negative NPV, while a lower rate of return may result in a false positive. Ensure to use a realistic interest rate while calculating the net present value to influence business decisions.

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Compare similar projects

The net present value depends on the interest rate and time. Projects have different risk elements that influence their feasibility and profitability. Financial analysts account for all factors while comparing two projects without relying solely on the net present value. When comparing two projects using NPV, all factors are identical.

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Use NPV as an indicator

NPV makes several assumptions in its calculation and is only an indicator of the profitability of a project. Several expenses and cash inflows may change during the execution of a project. Utilising the NPV value as one of the elements can allow businesses to make informed decisions.

Advantages of NPV

The net present value has several benefits in decision making. It is a comprehensive tool used by financial analysts to guide the management in making crucial financial conclusions. Some advantages of calculating the NPV are:

Time value of money

Inflation depreciates the value of money over time. Calculating NPV considers inflation and helps make judicious decisions. It understands that the cash flow in the future has a lesser value than the cash flow in the present. Calculating this value while accounting for inflation helps businesses compare similar projects and make informed decisions.

For example, Project X has higher cash flow in the initial years of its two-year life span, while Project Y has higher cash flow in the latter years of its two-year life span. Owing to NPV, an investor may conclude that Project X is a better option for investment, as the cash flow at the values of the current rate is higher than cash flows of the future.

Factors the risks of a project

Net present value is an effective method that factors the cost of capital and the risk inherent in making projections about the future. It regards the interest rates, financial risks and operating risks. Moreover, it considers all cash flows to understand the payback periods before an investment decision. Considering all risk factors helps the investor gauge the repercussions of an investment and the return they may receive on it.

Related: What Does A Risk Manager Do? (How To Become One And Skills)

Understand long-term goals

NPV helps investors understand the long-term return on investment. Since it factors all inflows, outflows and risks, it acts as a comprehensive measure to understand long-term benefits. With future cash flows at a discounted rate, it helps identify long-term value rather than identifying short-term projects with a quick rate of return.

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Factors affecting NPV

Net present value evaluates several variables in its calculation, making it harder to derive. Here are some of the factors to consider while calculating:

  • Check throughput on goods sold. Include cash flows from the throughput generated from the sale of goods. Calculate throughput by subtracting the total variable expense of the goods from the revenue it generates.

  • Account for the future sale of an asset. It is vital to pay attention to the assets purchased during the period for which NPV gets calculated. You may assume that the investment may generate cash from its eventual sale.

  • Note the change in working capital. There may be an incremental change in the amount invested and receivable due to various business or purchase decisions. Include these cash flows in the analysis as they may relate to the sale of an asset or termination of related working capital.

  • Calculate the maintenance costs. These costs are essential to maintain any purchased asset and require regular cash flow. The expenses associated with employees recruited for the maintenance do not affect the NPV calculation.

  • Account for tax payments. While calculating NPV, ensure to identify tax paid on assets such as property tax or incremental income tax. Similarly, understand the effect of income tax on the depreciation expense of an investment caused by tax deductions.

Examples of calculating NPV

Here are some hypothetical NPV calculations to help you understand the process:

Example 1

An investor wants to invest in Company ABC. The company requires an investment of ₹2,50,000. The investor expects a cash flow of ₹50,000 in the next 12 months. Begin by defining the terms for ease of calculation.

Cashflow: ₹50,000

Interest rate: 12%

Period: 1 year

Initial investment: ₹2,50,000

NPV = ∑ (Cashflow/(1+i)^t)-initial investment

NPV= 50000/(1+0.12) - 250000

*NPV= ₹-205,357.14*

A negative NPV value uses cash from a business without generating the necessary return on investment

Example 2

A company is evaluating the profitability of a project with an initial investment of ₹35,000. The project expects to generate a revenue of ₹10,000, ₹27,0000 and ₹19,000 in three years with an interest rate of 12%.

The cash flow over three years differs and requires the summation of individual cash flow results in the required net present value to determine the profitability.

Cashflow: ₹10,000, ₹27,0000 and ₹19,000

Interest rate: 12%

Period: 3 years

Initial investment: ₹35,000

NPV = ∑ (Cashflow/(1+i)^t)-initial investment

NPV = [10000/(1+0.12)^1]+[27000/(1+0.12)^2]+[19000/(1+0.12)^3]-35000

NPV= ₹8,977

Example 3

An investor wants to invest ₹50,000 in Project XYZ. It aims to generate a cash flow of ₹30,000 in the next two years. The interest rate is at 15%.

Cashflow: ₹30,000

Interest rate: 15%

Period: 2 years

Initial investment: ₹50,000

NPV = ∑ (Cashflow/(1+i)^t)-initial investment

NPV = [30000/1+0.15]+[30000/(1+0.15)^2]-50000

NPV= ₹2684.46

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