Net present value, or NPV, is one of several methods investors and companies use to evaluate the potential profitability of an investment or project. NPV measures the total amount by which an investment is expected to increase based on the present value of its potential cash flows and initial cost. You can calculate an investment's NPV to help you determine if you should accept or reject it. You want to find an investment with a positive NPV, which suggests it will be profitable.
Instructions
1. Estimate the investment's discount rate, or required rate of return, and the cash flows it will generate each year. The discount rate represents the annual return you could earn on a similar investment with equal risk. For example, assume your business is considering investing in new equipment that will generate cash flows of $1,200, $1,100, and $1,000 in the first through third years, respectively. Assume the discount rate is 8 percent.
2. Plug each cash flow, the year you will receive them, and the discount rate as a decimal into the formula cash flow / [(1 + discount rate)^year]. Use a different formula for each cash flow. In this example, the formulas are $1,200 / [(1 + 0.08)^1], $1,100 / [(1 + 0.08)^2] and $1,000 / [(1 + 0.08)^3] for the first through third years, respectively.
3. Add the numbers in parentheses of the first formula. Raise the result to the power of the exponent. Divide the numerator by that result to calculate the present value of the first year's cash flow. Also, calculate the formula for each additional year's cash flow. In this example, add 1 to 0.08 to get 1.08. Raise 1.08 to the first power to get 1.08. Divide $1,200 by 1.08 to get a present value of the first year's cash flow of $1,111. Calculate the other two formulas to get present values of $943 and $794 for the second and third year's cash flows, respectively.
4. Add the present value of each cash flow to get the total present value of the investment's cash flows. In this example, add $1,111, $943 and $794 for a present value of $2,848.
5. Subtract the initial cost from the total present value of its cash flows to calculate its net present value. Concluding the example, assume the initial cost is $2,000. Subtract $2,000 from $2,848 to get an NPV of $848. This means you expect the investment will generate a profit of $848.
Tags: cash flow, cash flows, discount rate, present value, present value, year cash, each cash
