Net Present Value (NPV)
The NPV is the difference between the present value of all future cash flows and the investment amount. NPV involves the discounting method of the value of money.
In brief, NPV allows investors and managers to determine the acceptable amount of money they will invest today in relation to the future cash flows.
The time value of money is basically a measure of how worthy the present money is in the future or how much the future value of money is worthy today. By making this comparison, it helps investors and managers to understand how much worthy is an investment.
NPV measures the profitability of an investment by computing the difference between the cash inflows of a given investment and the cash outflows.
So, literally it can be said that NPV can be calculated by determining the surplus between the present value of future cash flows and the initial investment.
If the present value of the cash flows are more than the initial investment or cash outflows, the investment is profitable. Alternatively, if the present value of the cash flows are less than the initial investment or the cash outflows, the investment is not profitable.
A positive NPV indicates that the investment is profitable, while a negative NPV indicates that an investment is not worthy investing. However, there may be other factors that an investor or manager may investigate before deciding to invest in a given investment.
NPV Formula
The formula for NPV is:NPV = Sum of Present Value of Cash inflows − Initial Investment or cash outflows
There are two ways to determine the present value of an amount:
a. PV of cash flow = [Cash flow ÷ (1+rate)^years])
b. Using factors from net present value of money tables.
Note: The Formula for calculating the NPV incorporates the present value tables. The values from the tables help to simply the formulas. Unless you use a financial calculator, you will need to use the NPV table. In this case, one should use the PV factor from the table which should be multiplied by the cash flow to obtain the Present value from a particular cash flow.
To better understand how NPV works, we have to look at a scenario that depicts such situations.
Example of NPV Problem - Scenario
Imagine Geminiards International are considering buying a new building and projects that the new property could have an estimated annual income of $250,000 for first year, $220,000 for the second year, $160,000 for the third year, $150,000 for the fourth year, and $140,000 for the fifth year.
Geminiards managers require an annual rate of return of 10% from the investment. The new building will cost Geminiards International $1,000,000 to buy the property. The new building will be useful only for 5 years after which Geminiards will sell the building for $100,000. Is the investment worthy it?
Solution to NPV Problem
| Year | Cash Flow | NPV Factor | Present Value |
|---|---|---|---|
| Year 0 | ($1,000,000) | 1 | (1,000,000) |
| First year | $250,000 | 0.90909 | 227,272.50 |
| Second year | $220,000 | 0.82645 | 181,819.00 |
| Third year | $160,000 | 0.75131 | 120,209.60 |
| Fourth year | $150,000 | 0.68301 | 102,451.50 |
| Fifth year | $140,000 | 0.62092 | 86,928.80 | Residue | $100,000 | 0.62092 | 62,092.00 |
| Totals | (219,226.60) |
NPV = Sum of PV of Cash flows − Initial Investment
NPV = $780,773.40 − $1,000,000 = − $219,226.60
The NPV for this investment is ($219,226.60). This is a negative NPV, and based solely on this NPV, the management should not purchase the building.