Definition:

Net Present Value or NPV analysis (also known as discounted cash flow method) is utilized to find the current value of future cash flows.

• What it is: NPV is one of the most common go/no-go decision tools in the business. If a business proposes to invest in an additional piece of manufacturing equipment, the NPV should tell them whether they will return more profit (discounted for time and uncertainty) than not investing. A positive NPV indicates that the projected earnings or returns of the project or investment (in present dollars) is greater than the required costs (also in present dollars). NPV is often used in the capital budgeting process to determine the profitability of a project or investment. As an example, would you be better off to take a recurring cash payment of $1 million per year for 20 years, or to take $15 million today?

• What it does: NPV calculates the future discounted value of cash inflows versus the present value of cash outlays. It does this by discounting and summing all future cash inflows by the company's minimum required return (often the company's cost of capital) and subtracting from the sum of the cash cost of starting the project. If the NPV is positive, the project should be approved, and if the NPV is negative, the project should be rejected.

Uses:

• How it is used: To determine if a project or product proposal should be implemented. Assuming there is no limit on available cash, all positive NPV projects should be approved. 

• Where: Companies use it in making decisions about buying equipment, adding people, launching products, etc. It can also be used to determine the value of an investment and whether it will return positive value compared to weighted average cost of capital (WACC).

• Why: It is a simple mechanism to communicate whether the investment will have a positive impact on the value of the company. In other words, should you make the investment or take the action?

Limitations:

• Where it shouldn't be used: NPV does not effectively compare investments of different sizes. If an NPV of $1,000 is forecasted for a project that you must invest $1,000,000 for and you compare it to a project that will receive $900 for a $1,000 investment, NPV would favor the $1,000,000 investment because it returns $100 more. But most people would prefer an NPV that was 90% of the initial investment over an NPV that was 10% of the initial investment.

• Any restrictions: NPV should not be used to compare investments when the size of the investments are different. In that case, you could use the net present value index or profitability index. The NPV index is calculated by the following formula:

NPV Index = NPV/Investment Required

Comparing the relative NPV Index of different investments will adjust for the differences in initial size of investment.

• Warnings:  Another problem with NPV is that you may need to adjust the discount rate when the risk associated with the future cash streams are very different or uncertain. The amount of the adjustment for uncertainty is often subjective, and can significantly impact the outcome of the NPV. In deciding on whether to launch a new product or business, a company with a WACC of 10 may require a discount rate of 25–50% to account for the uncertainty of the future profits forecasted for the new launch.

Demonstrations:

• LinkedIn Learning: How to calculate investment NPV in Excel

• YouTube: Net Present Value Explained in Five Minutes

Step-by-Step Process:

• Gathering data: Gather the following data for the analysis:

• Initial Cost

• Life of the future cash flow stream (in years)

• Size of the future cash flows (in dollars per year)

• Any residual value of the investment at the end of cash flow stream

• Required rate of return or discount rate (i.e, cost of capital)

• Analysis of data: In most cases you can use an Excel spreadsheet and utilize the NPV function to calculate the discounted cash flow (NPV). You can also calculate the NPV yourself using the equation below:

       where

Ct = net cash inflow during the period t

Co = total initial investment costs

r = discount rate and

t = number of time periods 

• Interpretation of results  Following the methodology would suggest the following interpretation:

• NPV > Cost of project → Project is Acceptable

• NPV = Cost of project → Project is Acceptable

• NPV < Cost of project → Project is Unacceptable

• Presentation of results 

• NPV is presented as a single number, or in comparisons between investments they can be shown in a table. NPVs can also be presented with the assumptions built into the calculation displayed in a table with the final calculated NPV.

Template for Capturing Data: