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How to Calculate Net Present Value?
In Investment Analysis, Net Present Value or NPV is one of the most used Financial Metric to determine the value of an investment or a business. This is commonly used since NPV provides a glimpse of the attractiveness of a project or investment, whether capital providers should invest or not in a project or a company. This enables them to capture if the risk they are taking will be compensated by the project or not.
In this article, you will learn What is NPV and its uses, how to compute it, and applying it to our financial decision-making.
Who Introduced NPV?
In 1887, an American civil engineer, A.M. Wellington, introduced the concept of NPV. This is due to the significant size of railway projects, thus creating a need for capital budgeting. Wellington is one of the first writers to consider the Present Value of investments. Though 1887 until the end of World War 1, there was no significant contribution to the formulation of NPV.
The first recorded use of NPV was in the 19th century. Popularized by Irving Fisher in his book The Rate of Interest (1907), economic literature, and later revised and reissued in 1930 as The Theory of Interest.
What is Net Present Value (NPV)?
Net Present Value (NPV) is the value of all future cash flow, positive or negative, over the life span of the investment discounted to the present. This helps investors or businessmen evaluate whether the investment or project would compensate for their risk. Whether acquiring a company, analyzing a company expansion, purchasing an asset, etc., NPV does provide a snapshot of the potential of the investment.
To know if an investment is worth taking is by the result of the calculated NPV. A Positive NPV indicates that the investment is profitable and should be accepted, while a Negative NPV indicates that it should decline since the risk taken by the investors will not be compensated, and they should invest elsewhere.
Why Use Net Present Value?
Net Present Value (NPV) is widely used by investors since it eliminates the time element when comparing different investments. In computing the NPV of investments, investors use a discount rate to reflect the different levels of risk. If the investment has higher risks, it uses a higher discount rate and a lower discount rate if otherwise.
There are several cases in how Net Present Value can be used:
Valuation
NPV can be used in estimating the value of a company or an asset based on its projected future cash flow with the consideration of the discount rate based on the level of risk in the industry the company is in. This will enable capital providers to be guided on whether they will pursue the investment or not.
Investment Analysis
NPV guides the management in assessing a project based on the benefits it will provide and the cost needed to obtain such a project. This can be also used to analyze options of the same size; comparing options will guide management on which investment to pursue.
What is the Formula for Net Present Value (NPV)?
As in its name, Net Present Value is the sum of the Present Values of all the expected Future Free Cash Flows of a company or an asset. Present Values are determined by applying the discount rate to be used to the projected future cash flow.
The Discount rate is the level of risks the investors are taking; a higher-risk investment constitutes a higher discount rate, while a lower-risk investment uses a lower discount rate.
The formula to determine the Net Present Value is:
This might be a little tricky, but fortunately, Microsoft Excel has an NPV Formula we can use.
NPV = NPV (rate, value1, value2….)
When using the NPV formula in Microsoft Excel, the rate is the discount rate determined, and the Values are the projected Future Cash Flow of the investment.
How to get the Cash Flow and Discount Rate?
In computing the NPV, two main items are needed to ensure accuracy: The Future Cash Flow and the Discount Rate.
One way of forecasting the Future Cash Flow of a company is through Bottoms-up Forecasting. Bottoms-Up Forecasting is a method used to determine the company’s future performance based on the low-level data and work up to generate the top line, Revenue. A business plan and financial plan of a minimum of 5 years can be created outlining the expected revenues, cost, and investments which results in an annual free cash flow forecast. This free cash flow forecast now can be used in our NPV formula.
While the Discount rate will depend on the risks capital providers are taking and how much return they expect. This requires an in-depth analysis of the Weighted Average Cost of Capital (WACC) and cost of capital where we analyze the return of similar investments like the stock market and derive the required compensation for equity and debt providers. To learn more about WACC and how to calculate it, please feel free to check our Weighted Average Cost of Capital (WACC) article.
The computation of NPV might be a little simple, but its accuracy greatly relies on subjective estimates. The Year-on-Year Future Cash Flow will greatly rely on Financial Forecasts, the best way to do so is using Bottoms-Up Forecasting, and if there is, the exit value of the investment after a certain number of years will greatly depend on the Financial Forecasts also.
Using NPV Calculation for a Trademark
NPV Analysis can work for valuing an asset or a company. In this calculation, we will analyze the NPV of a Trademark with 10 years of cash flow as an example reference.
In the example above, we provided the assumptions (cells with text in blue). Using one of the features available in MS Excel makes this calculation very easy to conduct as we only need to use the standard Excel formula = NPV (10%, “Year 1: Year 10”).
How to Deal with Negative NPV?
Negative NPV is the least output an investor wants to see because this shows that the potential investment they are looking at will not be profitable and should not be pursued since their investment will not be properly compensated.
Let’s say an investor is looking at acquiring KNP Motor Company based on the Financial Forecast provided, will the investment be compensated after 7 years.
In this situation, NPV is negative. This means that this project cannot generate the required return to compensate its capital providers for the risk of this project.
This also means that investors are better off investing their money elsewhere, like the stock market, where they can obtain a better return. Therefore, from an economic and financial perspective, this investment is not wise since the NPV is negative (positive NPV is the desired outcome).
The recommendation here would be not to make this acquisition. Please note that this is all based on a subjective forecast which can be challenged by different views that may result in further discussions.
Also, a negative NPV may differ for different capital investors since their risk perceptions differ. Some prefer an investment with a lesser reward with a lesser risk investment, but some prefer a higher reward investment and are ready to take the higher risk along with it. Thus, if the investment is assumed to have lesser risk, the NPV might be positive.
The Limitations of NPV Calculation
Though NPV is a great tool for business decision-making, it has some limitations to its use that should be considered when using it:
NPV is based on estimates
NPV is based on estimates. Future Cash Flow and discount rates are the main components in determining NPV, all subjective estimates. Therefore, the quality of NPV calculations stands and falls with the quality of the forecast and its analysis.
Short-term Bias
NPV cannot determine attractive returns in the long term because their Present Value will result in low amounts. NPV favors cash flow in the near term since the closer the year is, the higher its Present Value.
Project Sizing
Net Present Values’ result is an amount; technically, the higher the amount, the more attractive it is. The problem is that one project requires a bigger capital outlay (investments), which appears to be more attractive than a project requiring a smaller capital outlay. In that case, it is better to use Internal Rate of Return Analysis (IRR) in analyzing this kind of scenario.
Does not consider non-cash benefits
In computing NPV, we only consider the Cash Inflow and Outflow of the project. Some projects’ benefits do not equate to cash, such as brand awareness or other qualitative aspects that are difficult to quantify.
Other Methods for Financial Decision Making
With the limitations of NPV, some financial metrics can help us in our decision-making.
The Internal Rate of Return (IRR) is a method used to determine if a project will be profitable or not. IRR Method provides the percentage of return of investments. This gives an apple-to-apple representation of two different projects. In IRR, we use the discount rate as a metric to determine whether we will accept the investment.
This method determines the period the investment repays the initial cash outflow. As in the name itself, “Payback” computes how long will the investors recover the initial investment without considering the time value of money.
NPV is one metric you need to know
The Net Present Value (NPV) is a useful method commonly used in capital budgeting. The main advantage of using NPV is the consideration of the discount rate, which also considers the time value of money. There might be some limitations or disadvantages in using NPV, but it structures our financial decision-making.
Determining NPV might be a little tricky to some extent. Fortunately, Microsoft Excel has incorporated the Formula to easily determine NPV.
Here is a free-to-download NPV Calculator: Net Present Value Calculator
To understand further and easier for you to apply NPV Analysis, we have prepared NPV Templates in Excel. Please check out and download our NPV Calculators in industry-specific financial model templates.
