Net Present Value (NPV): Definition, Examples & Calculation
Net Present Value (NVP) is one of the ways to analyse an investment to see if it's worth the risk.
You might find it useful if you’re working out whether or not to invest in new equipment for your business.
NVP is also an important indicator of how profitable a potential investment in another business will be and is often used as part of investors’ overall appraisal.
But what exactly does it tell you and how do you calculate it?
Here’s What We’ll Cover:
What Is Net Present Value?
Net Present Value is an accounting calculation that’s used to help make decisions about investments. It’s more useful than some other investment indicators because it takes the ‘time value of money’ into account.
‘Time value of money’ is the concept that money you have now, in the present, is worth more than any future money.
For several reasons:
- You can buy something with current cash and sell it for a profit later on
- You can use the money now, in your business, to make even more money
- Inflation diminishes the value of future cash
The value of current cash inflows is known, certain and it has the potential to make a return. But there are risks involved in relying on any future cash. Right up the scale to will it even arrive at all.
Any predictions about money you’re going to make in the future must allow for this decreased cash value and how it compares to initial investment. It's an important part of figuring out the Return On Investment (ROI) of a new project or investment.
But how can you know what the future value of money will be now? There’s a calculation for that!
In accounting, this predictive equation is known as the ‘present value of future cash flow’. This is the foundation of working out the overall Net Present Value of a project or investment.
How Do I Calculate Net Present Value?
The calculation for Net Present Value itself isn’t too complex. But it does need initial definitions of its component parts, so it makes sense. We’ve already got the concept of the time value of money. Here are the other terms you need to get to the Net Present Value calculation.
This is sometimes called the discount rate. The discount factor is the cost of borrowing money or the rate of return payable to investors. It’s specific to the business in question and usually set by the Chief Financial Officer. It's usually based on interest rates and takes inflation into account.
- Rate of return expected by the shareholders is 13%.
- Discount rate used in the Net Present Value calculation = 0.13
Present Value of Future Cash Flow
Taking each separate origin of cash independently, you apply the following calculation:
Cash flow X Discount factor = present value of future cash
- Predicted future cash flow of £30,000
- Discount factor of 0.9
- £30,000 X 0.9 = £27,000
- Present value of this future cash is £27,000
The value of that future £30,000 cash flow now is £27,000.
Net Present Value
Working out the net present value of a project or investment starts simply by adding together all the present values of the relevant future cash flows. This gives you the total monetary value now of that future cash. Then you deduct the total amount of investment - cash outflows - to give you the Net Present Value.
Taking your original investment and the time value of money into account, is this going to be profitable?
NVP = Today’s value of expected cash flow - Today’s value of invested cash
Example Net Present Value Calculation
You’re considering a £100,000 investment in a business development project. You want to know if this is likely to be profitable, based on projected profit figures which are:
- Year 1: Make £40,000 profit
- Year 2: Make £50,000 profit
- Year 3: Make £60,000 profit
As it stands, this leaves an overall return of £50,000 on your £100,000 investment.
Total of 3 years’ profits - initial investment
£150,000 - £100,000 = £50,000
But you know that this future money is worth less than today’s money, so you want to get a more accurate picture by using the Net Present Value Calculation.
- Year 1: £40,000 X 0.91 discount factor = £36,400
- Year 2: £50,000 X 0.83 discount factor = £41,500
- Year 3: £60,000 X 0.76 discount factor = £45,600
Now the total of 3 years projected profits is £123,500
The NVP is £100,000 - £123,500 = £23,500
Substantially less than the previous £50,000 figure. But this is still considered a positive NPV, and indicates that the investment opportunity is worthwhile.
Most of today’s accounting software and financial spreadsheets have a built-in NPV formula that automatically generates the necessary calculations. This removes the time consuming element of working out the Net Present Value that has always been a deterrent.
What Does the Net Present Value Tell You?
The Net Present Value tells you if your investment is likely to make a profit over a set period of time.
Positive Net Present Value
Once you add up all your present values of future cash, you need to compare that figure to the amount you're thinking of investing. If the total of all the present values is bigger than the initial investment, then you’ve got a positive net present value.
This means that you’ll make more in this investment than you would on interest if you put the same amount of money in the bank. A good investment.
Negative Net Present Value
On the other hand, if your initial investment figure is higher than the total of the present value of future cash, you have a negative net present value.
This means that this is a bad investment, on track to make a loss and not worth the risk.
Zero Net Present Value
If the result of your calculation is precisely zero, this means that the investment will only make the discount interest. As this means that there is no foreseeable profit, there’s no benefit to this investment. You’d get the same return, possibly at much less risk, if the money sits in a savings account.
Comparing Investment Opportunities
Net Present Values for alternative investments can be used to directly compare their potential. This might be investors looking at different companies. Or business owners like you deciding between different capital investments.
And the outcome couldn't be simpler - the investment with the highest Net Present Value is the most likely to give you a good return on your initial cost.
How Does NPV Compare To Other Investment Appraisal Formulas?
As well as Net Present Value, there are several other ways to examine a potential investment:
- Accounting Rate of Return (ARR): Also called the Average Rate of Return. This calculates the annual percentage rate of return against the initial investment.
- Payback Method: How many years it will take to repay the initial investment from the net cash flows. Lots of companies like the simplicity of the payback method, although it doesn't provide the detail necessary for effective investment planning.
- Internal Rate of Return (IRR): This is very like NPV but the discount rate used brings the Net Present Value to zero. The internal rate of return measurement determines if the cost of capital put into a project will break even over a period of time.
- Discounted Payback: A discount is applied to cash inflows before adding them together to workout the payback period.
Compared to these other appraisal methods, the main benefits of Net Present Value calculations are:
- The Net Present Value formula is based on the concept of the time value of money. This makes it a more complex calculation and provides a deeper insight into the investments’ potential.
- Even though it’s doing a complicated thing, the formula is comparatively simple to use.
- The result is a definitive figure that can easily be used when comparing different opportunities.
Whether you’re making a big investment into your business, or looking to put investment funds into another organisation, the more information you have the better. Each of these appraisal tools provide different information that may put the investment in a better, or worse, light. In order to make sensible investment decisions, you need to look at things from as many different angles as possible.
As the Institute of Chartered Accountants in England and Wales (ICAEW) summarises “Most companies use several methods to assess a significant investment project as part of the investment appraisal process. Different methods can give conflicting results and so care should be taken.”
What Mistakes Can Be Made When Using Net Present Value?
There are some pitfalls to using Net Present Value:
- The calculation doesn’t take interest on debt or credit into account
- NPV also doesn’t involve any consideration for taxes
- Aside from the initial investment figure, the entire calculation is based on subjective predictions. The whole result is based on, as yet unsubstantiated, predictions.
Looking deeper into where you can keep your figures tight is a good way to make your Net Present Value more accurate and useful. Ask yourself these three questions:
- Are you certain of the initial investment figure, or might that change? Buying a piece of equipment at a set price is a nice concret number. But what if you’re looking to upgrade a service or increase staff numbers? How definite is that total?
- How optimistic are my projected future cash flow returns? You don't want to be pessimistic, but are they realistic? It’s very easy to get carried away by the enthusiasm of a project’s potential. But overly optimistic numbers will skew the Net Present Value calculation.
- Discount rates are based on today’s interest rates because they have to be, unless there’s a working crystal ball in the vicinity! But your future returns can be hugely affected by any sudden change in that interest rate. Some people prefer to use a higher rate of discount to account for this and other unanticipated factors that affect future revenues.
It can also be tricky to explain to people that aren’t used to using Net Present Value in their decision making. As you’ll appreciate, if you’re reading this as a newbie. But it’s a convincing metric if you can make the time to get colleagues, or potential investors, to understand.