What is Net Present Value?

706 1 0 March 2, 2023

NPV: Determine how much your cash flow, project, or investment is worth

Are you planning to start a business or want to grow an existing one? Then, it would be best never to forget the acronym, CREAM – Cash Rules Everything Around Me. For the record, insufficient cash flow is the number one reason why small businesses fail. Businesses typically have limited amounts of cash or resources available. So, entrepreneurs and managers must wisely choose how to allocate capital. One of the best ways to do this is to evaluate your assets, projects, or investments in light of the expected shareholder value they can create. That’s why you might want to calculate Net Present Value (NPV). Such a financial metric puts future cash flows in the context of today’s value. It will then help you analyze how to mitigate the risks.

The Definition of Net Present Value

Many rely on financial metrics to avoid wrong choices and support solid investment decisions. These include the Internal Rate of Return (IRR), payback period, and Return on Investment (ROI). But to appraise a particular expenditure or project in light of its capacity to create value for your business, you might want to calculate the NPV. It starts by looking at all the money you expect to make from such an investment. Then after translating those returns into today’s dollars, you’ll be able to determine if the investment is worthwhile.

Net Present Value is the present value of a future stream of free cash flows, discounted and summed up to their current worth. “Net” refers to the net cash flows, meaning we deduct the cash outflows from the cash inflows to get the net free cash flows. Furthermore, calculating the discount rate should reflect the risk of a company or a project. It can be calculated by looking at how much return an investment in an asset of similar risk will yield.

How to Calculate Net Present Value?

The net present value formula is:

Since the NPV formula involves summation, it might be a little tricky. Fortunately, you can now use an Excel NPV calculator to make everything accurate and easy.

How to Calculate NPV in Excel?

The spreadsheet function for calculating net present value is through discounted cash flow calculation. So, there are two main factors that you will need to calculate accurately – your future cash flow and the discount rate.

Future Cash Flow

Future cash flow indicates how much the business expects to earn and spend. You can model the cash flow forecast for several days, weeks, months, or years. The process can be arduous, but it is worthwhile since you can plan your operational business most effectively with a precise forecast of future cash flows.

Bottom-up Forecasting is one method for predicting a company’s future cash flow. It is a technique used to indicate the company’s future performance based on low-level data and work up to produce the top line – revenue. Another method is top-down Forecasting. It forecasts the market share and revenue a firm can conceivably attain by examining the more extensive market and competitive landscape.

Discount Rate

The discount rate is the interest rate used to calculate the net present value (NPV) of a project’s future cash flows. It depends on the risks that capital providers, investors, and lenders may take together with their expected returns.

To accurately estimate the discount rate, you can analyze the weighted average cost of capital (WACC) in-depth. The method determines the capital costs for similar investments, i.e., the stock market, to get the equity and debt providers’ compensation. Please feel free to check our article to learn more about WACC. We also have a WACC Calculator/Discount Rate Estimation, which you can use for any discounted cash flow calculation.

Calculation of Net Present Value Using an NPV Calculator

Our NPV calculator is an Excel template that you can download for free. It is a valuable tool that calculates the Net Present Value of a future stream of future Free Cash Flow.

Download the FREE NPV Calculator here:

Net Present Value Calculator | eFinancialModels

Here’s an example of how to use it:

In the sample above, we have assumed the forecast period as one year – starting from the valuation date of 01 January 2023 to 31 December 2023. Other assumptions include the following:

Revenue or Future Cash Flow =$200,000
Discount Rate = 10%
Revenue = $200,000
Growth Rate from Year 2 onwards = 10% (Note: We use a fixed assumption of 10% annually. But can we can vary per year)
Gross Profit Margin % = 50% (Note: We use a fixed assumption of 50% annually. But can we can vary per year)
Depreciation Rate = -$8,000 (Note: We use a fixed assumption of -$8,000 annually. But can we can vary per year)
CAPEX = -$50,000
Change in Net Working Capital for Year 1 = -$50,000
Change in Net Working Capital for Year 2 to Year 10 = -$5,000 every year
Exit Value = $300,000

After putting the assumptions, the NPV calc auto-calculates everything, including the discount period and discount factor. The NPV value turns out to be $411,044, a positive value that indicates profitability.

What NPV Can Tell You

NPV can assess the perceived profitability of a new investment or project. Entrepreneurs, finance analysts, and managers use it to guide investment and operating decisions.

If the NPV is positive, the investment is profitable and should be accepted; if it is negative, the investment should be declined because the investors’ risk will not be repaid. Instead, they should look for other investment opportunities. Please remember that the preceding principles are generalizations and not rigid rules. Many financial planners set a higher bar for NPV as a margin of safety. It accounts for marginal errors since we use estimates to calculate NPV.

Why Calculate NPV?

Calculation of net present value is vital to handling budgets and ranking projects. Hence, many investors and lenders use NPV to determine which acquisition or merger is worth it. For accountants and entrepreneurs, NPV can help decide which projects to prioritize.

The following circumstances call for an NPV analysis:

DCF Valuation
Analyses of Investment Projects
Quantification of Synergies
Complementing other financial metrics

NPV Used in DCF Valuation

In simple terms, valuation means estimating the monetary value of an asset, company, or project. In business valuation, the result of discounted cash flow analysis is the net present value. Based on estimates of how much money an investment will make in the future, it seeks to evaluate the investment’s value today.

When appraising the value of an asset, i.e., a brand or patent, NPV forecasts future royalties. Such forward-looking offers many advantages over backward-looking valuations, i.e., net asset value considerations. It is also easier to calculate than other valuation methods, e.g., multiple market valuations.

Furthermore, NPV can perform an accurate company valuation to help in financial well-being and future exit strategies. It enables you to improve cash flow and spot operational inefficiencies, both of which increase the worth of your company.

Last, the calculation of net present value enables capital providers to check whether the risk of pursuing the project will reap their expected returns.

NPV Allows Comparisons of Investment Projects

The expected NPVs of various investment projects can be compared to each other to understand better which project allows to generate the most value for shareholders. The beauty here is that the risk of each project can be different, which can be easily factored in by using different discount rates for each project. The resulting NPV value can then be compared and ranked between projects.

Please note, a negative NPV indicates that the expected rate of return will be lower than the discount rate, which means that the project won’t add value, regardless of how the discount rate is calculated. Such projects should not be pursued from a capital allocation point of view as they destroy shareholder value.

One weakness here is that the size of NPV is also determined by their project sizes. So large investment projects should naturally also generate large NPVs, while smaller projects, due to their size only, can create smaller NPVs. To make up for this shortcoming, calculating the Internal Rate of Return might be a better idea here, as the output will be a percentage figure which can easily be compared.

NPV Allows you to Quantify Synergies

Regarding acquisitions and mergers, the NPV valuation method lets us quickly quantify expected synergies from additional revenues or savings when merging two companies. When negotiating Mergers and Acquisitions, knowing the value of such synergies to optimize the price negotiations in such transactions can be beneficial.

NPV Conceptualizes Shareholder Value Assessment

Investors and lenders commonly demand the returns they will receive from an investment in numbers. Even the management team also requires evaluating the value a project will offer over the expenses required.

Many financial analysts use NPV to conceptualize these benefits, especially when there’s a need to quantify them in numbers. First, NPV accounts for the time value by converting future cash flows into today’s money. Second, it shows a specific figure contrasting the initial investment with the present worth of returns.

NPV Complements Other Financial Metrics in Investment Analysis

NPV is commonly used in valuation. But it can also be a tool for analyzing investment cases and returns, especially if it’s not feasible to calculate IRR. Such a case includes having negative cash flows over positive cash flows.

As IRR only functions in consistent positive cash flows, a negative cash flow can lead to multiple inconclusive mathematical results. An effective NPV financial model enables the assessment of the effects and the simulation of critical assumptions on sensitivity analysis like that of IRR. To determine when it is best to use NPV and IRR in financial decision-making, refer to our article about IRR vs. NPV.

Conversely, NPV complements other financial metrics, like payback period, return on investment (ROI), and investment multiple.

Payback analysis is an easy and quick metric of how long it takes to recover your money. Side by side, you can use it with NPV to present the value created when investing your money.
ROI is a simple alternative to IRR analysis. It is the annual cash-on-cash yield of a particular investment. As ROI is a stand-alone percentage measuring the return on capital in an investment, you can complement it with NPV to show the return value in absolute numbers.
Investment multiple

Pros & Cons of NPV

Understanding the pros and cons of NPV before basing business and financial decisions on such methodology is essential. Although its quantified value is an absolute number, it also has limitations.

Pros

NPV accounts for the time value of money. It shows that cash flows today have more weight than the same cash flows in the future. As it calculates the intrinsic value of an asset, company, or project based on future cash flow expectations, it determines the number value of returns.

Unlike IRR, NPV is not affected by positive and negative cash flows. Furthermore, it is a forward-looking valuation with many advantages over backward-looking valuations, such as net asset value considerations. Since it is based on free cash flow, you can manipulate the calculation of net present value.

Cons

The biggest downside of NPV is not being able to use it when comparing projects of different sizes. The NPV results may need more accuracy as the most extensive projects typically generate the highest returns. Besides, NPV is hard to explain and understand because it only gives a partial picture of gain, loss, and opportunity cost.

It also shows the expected number value. Yet, most investors and lenders commonly want to know the predicted percentage of returns. Since NPV requires guesswork, estimating future cash flows can be biased or subjective.

Summary

Many rely on financial metrics like IRR, payback, and ROI to avoid wrong choices and support solid investment decisions. But to appraise a particular expenditure or project, you must calculate the net present value or NPV. It uses a discount rate to translate future cash flows into the current number value.

NPV can be used in DCF valuation, rate of return comparisons, shareholder value assessment, and to complement other financial metrics. Generally, a positive NPV indicates profitability, while a negative one shows that the investment may not be worthwhile. Today, it is easier to calculate the net present value using an Excel template or NPV calculator. You can input the assumptions you believe are most realistic to estimate best the range of where a reasonable value should lie within.