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Formulas and Calculation: NPV Calculations

This document discusses net present value (NPV) calculations for capital budgeting. NPV represents the change in a company's net worth from accepting a project over its life. It is calculated by discounting a project's expected cash flows using the weighted average cost of capital. NPV requires projected cash flows, initial investment, and discount rate. Positive NPV projects increase firm value and should be accepted, while negative NPV projects decrease value and should be rejected. NPV accounts for the time value of money but does not consider project size.

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30 views3 pages

Formulas and Calculation: NPV Calculations

This document discusses net present value (NPV) calculations for capital budgeting. NPV represents the change in a company's net worth from accepting a project over its life. It is calculated by discounting a project's expected cash flows using the weighted average cost of capital. NPV requires projected cash flows, initial investment, and discount rate. Positive NPV projects increase firm value and should be accepted, while negative NPV projects decrease value and should be rejected. NPV accounts for the time value of money but does not consider project size.

Uploaded by

sadianasir960
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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NPV Calculations - by Irfanullah Jan, ACCA and last modified on Jun 21, 2019

Net Present Value (NPV)


Net present value (NPV) of a project represents the change in a company's net worth/equity that would result
from acceptance of the project over its life. It equals the present value of the project net cash inflows minus the
initial investment outlay. It is one of the most reliable techniques used in capital budgeting because it is based
on the discounted cash flow approach.
Net present value calculations require the following three inputs:
 Projected net after-tax cash flows in each period of the project.
 Initial investment outlay
 Appropriate discount rate i.e. the hurdle rate.
Net after-tax cash flows equals total cash inflow during a period, including salvage value if any, less cash
outflows (including taxes) from the project during the period.
The initial investment outlay represents the total cash outflow that occurs at the inception (time 0) of the
project.
The present value of net cash flows is determined at a discount rate which is reflective of the project risk. In
most cases, it is appropriate to start with the weighted average cost of capital (WACC) of the company and
adjust it up or down depending on the difference between the risk of the specific project and average risk of the
company as a whole.

Formulas and calculation


The first step involved in the calculation of NPV is the estimation of net cash flows from the project over its
life. The second step is to discount those cash flows at the hurdle rate.
The net cash flows may be even (i.e. equal cash flows in different periods) or uneven (i.e. different cash flows
in different periods). When they are even, present value can be easily calculated by using the formula
for present value of annuity. However, if they are uneven, we need to calculate the present value of each
individual net cash inflow separately.
Once we have the total present value of all project cash flows, we subtract the initial investment on the project
from the total present value of inflows to arrive at net present value.
Thus we have the following two formulas for the calculation of NPV:
When net cash flows are even, i.e. when all net cash flows are equal:

1 − (1 + i)-n
NPV = R × − Initial Investment
i

In the above formula,


R is the net cash inflow expected to be received in each period;
i is the required rate of return per period (i.e. the hurdle rate, discount rate);
n are the number of periods during which the project is expected to operate and generate cash inflows.
When net cash flows are uneven, i.e. when net cash flows vary from period to period:

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NPV Calculations - by Irfanullah Jan, ACCA and last modified on Jun 21, 2019

R1 R2 R3
NPV = + + + ... − Initial Investment
(1+i) 1 (1+i) 2 (1+i) 3

Where,
i is the hurdle rate (also called discount rate);
R1 is the net cash inflow during the first period;
R2 is the net cash inflow during the second period; R3 is the net cash inflow during the third period, and so on ...
These formulas ignore the effect of taxes and inflation. Read further: NPV and taxes, NPV and
inflation and international capital budgeting.

Decision rule
In case of standalone projects, accept a project only if its NPV is positive, reject it if its NPV is negative and
stay indifferent between accepting or rejecting if NPV is zero.
In case of mutually exclusive projects (i.e. competing projects), accept the project with higher NPV.

Examples
Example 1: Even net cash flows
Calculate the net present value of a project which requires an initial investment of $243,000 and it is expected to
generate a net cash flow of $50,000 each month for 12 months. Assume that the salvage value of the project is
zero. The target rate of return is 12% per annum.
Solution
We have,
Initial Investment = $243,000
Net Cash Inflow per Period = $50,000
Number of Periods = 12
Discount Rate per Period = 12% ÷ 12 = 1%
Net Present Value
= $50,000 × (1 − (1 + 1%)-12) ÷ 1% − $243,000
= $50,000 × (1 − 1.01-12) ÷ 0.01 − $243,000
≈ $50,000 × (1 − 0.887449) ÷ 0.01 − $243,000
≈ $50,000 × 0.112551 ÷ 0.01 − $243,000
≈ $50,000 × 11.2551 − $243,000
≈ $562,754 − $243,000
≈ $319,754
Example 2: Uneven net cash flows
An initial investment of $8,320 thousand on plant and machinery is expected to generate net cash flows of
$3,411 thousand, $4,070 thousand, $5,824 thousand and $2,065 thousand at the end of first, second, third and
fourth year respectively. At the end of the fourth year, the machinery will be sold for $900 thousand. Calculate
the net present value of the investment if the discount rate is 18%. Round your answer to nearest thousand
dollars.

Page 2 of 3
NPV Calculations - by Irfanullah Jan, ACCA and last modified on Jun 21, 2019
Solution
PV Factors:
Year 1 = 1 ÷ (1 + 18%)1 ≈ 0.8475
Year 2 = 1 ÷ (1 + 18%)2 ≈ 0.7182
Year 3 = 1 ÷ (1 + 18%)3 ≈ 0.6086
Year 4 = 1 ÷ (1 + 18%)4 ≈ 0.5158
The rest of the calculation is summarized below:

Year 1 2 3 4

Net Cash Inflow $3,411 $4,070 $5,824 $2,065

Salvage Value 900

Total Cash Inflow $3,411 $4,070 $5,824 $2,965

× Present Value Factor 0.8475 0.7182 0.6086 0.5158

Present Value of Cash Flows $2,890.68 $2,923.01 $3,544.67 $1,529.31

Total PV of Cash Inflows $10,888

− Initial Investment − 8,320

Net Present Value $2,568 thousand

Strengths and weaknesses of NPV


Strengths
Net present value accounts for time value of money which makes it a better approach than those investment
appraisal techniques which do not discount future cash flows such as payback period and accounting rate of
return.
Net present value is even better than some other discounted cash flow techniques such as IRR. In situations
where IRR and NPV give conflicting decisions, NPV decision should be preferred.
Weaknesses
NPV is after all an estimation. It is sensitive to changes in estimates for future cash flows, salvage value and the
cost of capital. NPV analysis is commonly coupled with sensitivity analysis and scenario analysis to see how
the conclusion changes when there is a change in inputs.
Net present value does not take into account the size of the project. For example, say Project A requires initial
investment of $4 million to generate NPV of $1 million while a competing Project B requires $2 million
investment to generate an NPV of $0.8 million. If we base our decision on NPV alone, we will prefer Project A
because it has higher NPV, but Project B has generated more shareholders’ wealth per dollar of initial
investment ($0.8 million/$2 million vs $1 million/$4 million).

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