The money you have now is said to be more valuable than the same amount of money you expect later. Why is this so? If you have a certain amount of money presently, you can use it to buy something now that you could sell later at a profit. You can use the net present value to compare the value of money today, and its value in the future. This article will provide an overview of the time value of money, and a guide on how to calculate net present value. Read on to learn how to calculate NPV using the excel function, or the formula.
Understanding the Net Present Value
Overall, the net present value is an appraisal method that businesses use to determine if a capital investment is worth the while at a given initial investment. In order for businesses to find out if a new project will be profitable, they need to know how to calculate net present value. This method works on the premise that posits that a dollar in the future is worth less than a dollar today. You can use it to evaluate the present value of your company’s future cash flows and investments.
Categories of net present value
Positive net present value – when the net present value is positive, it implies that you are paying less than what an asset is worth. For instance, when the discount rate is lower than the internal rate of return, your net present value will be positive. In order for you to earn more on your investment project, you have to pay less than its value so that you can achieve the desired cash flow.
Negative net present value – if the net present value is negative, this implies that you are paying more than what your asset is worth. If the NPV is negative, you should not undertake the investment.
Zero net present value – this is the third category, and if your net present value is termed as zero, it implies that what you are paying is the exact worth of an asset. When your NPV equals zero, your discount rate is equal to your internal rate of return. This means that the value of your investment is equal to its cost.
How to Calculate Net Present Value
Have you been wondering how to calculate net present value? The easy way is to use the excel function. The hard way is to apply the formula, and calculate by yourself.
How to Calculate Net Present Value in Excel
Here is how to calculate net present value using the excel function:
- Collect the details of the scenario you want to calculate NPV for.
- Launch the MS Excel application, and open a new Excel workbook to do your calculation.
- Set a discount rate in a cell.
- Establish a series of cash flows. These have to be in consecutive cells.
- Determine the timing of your initial investment.
- Click the function button labeled “fx” to choose the NPV function.
- Alternatively, type “=NPV(“.
- Select the discount rate, introduce the number of your rate, then hit the comma button (,).
- Select value 1, value 2, value 3 (as applicable in your case), and introduce the number of those numbers, followed by comma.
- End the process by typing the round bracket “)”.
- Hit Enter. The excel will show you the NPV for the values you introduced.
Net Present Value Formula
There is also a formula applied by enthusiastic analysts to calculate net present value. The formula applied is as follows:
Net Present Value = Σ (Year n Total cash Flow) / (1 + Discount Rate)ⁿ
Where ‘n’ is the year whose cash flow is being discounted.
The above is the sum of the present value of cash flow for every year that is connected with your respective investment. In order to do it, you must calculate the present value of each year’s estimated returns by taking the year’s projected cash flow. You will then divide it by (1 + the discount rate).
Written down, the formula is as follows:
(FV₁)/((1 + Discount Rate)ⁿ)
In the above equation, ‘FV’ represents the projected cash flow for each year, whereas ‘n’ is the number of years the cash flow is from the present.
For instance, the cash flow for 6 years using the above equation would appear as follows:
(FV₁)/((1 + Discount Rate)⁶)
If your investment project brings in returns for the 6 years, you are supposed to calculate the figure for each of the 6 years and then find their sum. The value you get is the present value of your investment’s projected returns. In order to get the net present value, you are required to subtract your initial investment from the value that you will get.
The discount rate used varies from one industry to the other because it is set according to the returns of a company. The discount rate is usually the rate of return that your investors expect. It may also be the cost of borrowing money. When you apply this formula, you may get a positive, negative, or zero NPV.
You might also like: How to Calculate Opportunity Cost
Applications of Net Present Value
The net present value is crucial to any company since managers can use it to determine which project is worth investing. The NPV shows the returns that investment will bring. Financial analysts prefer using the net present value over other available options because it puts into consideration the time value of money, which is essential in determining future cash flows.
Moreover, this method is ideal because it provides you with comprehensive figures that make it easy for you to compare your initial investment against the present value of your return. The net present value is also applied in mergers and acquisitions, and it is among the most preferred method by people evaluating if they should make a large purchase.
Practical Example of Knowing How to Calculate Net Present Value
Let’s say that a company, Wi-Comm Softwares intends to purchase an equipment that is to aid in its installation services. The equipment will cost $6,000, and it will improve each year’s cash flow by $2,200. The equipment has a useful life of 6 years and there is no salvage value expected from it. The executives want a 20 percent ROI.
How to calculate net present value of this project:
Initial cost = $6,000
Useful life = 6 years
Annual cash flow = $2,200
Required rate of return = 20%
Year 1 – 2200/(1+20%)^1 =$1,833.33
Year 2 – 2200/(1+20%)^2 =$1,527.77
Year 3 – 2200/(1+20%)^3 = $1,273.15
Year 4 – 2200/(1+20%)^4 =$1,060.96
Year 5 – 2200/(1+20%)^5 =$884.13
Year 6 – 2200/(1+20%)^6 =$736.77
Total present value of cash inflows = $1,833.33+ $1,527.77+ $1,273.15+ $1,060.96+ $884.13+ $736.77 = $7,316.11
Net Present Value = $7,316.11 – $6,000 = $1,316.11
It is advisable for Wi-Comm to purchase this equipment. This is because the equipment has a positive net present value of $1,316.11. This means that this investment will bring in a higher rate of return than the one stipulated by the investors.
If you run a company, it is important to know how to calculate the net present value. Using the methods discussed above allows you to find the NPV of any investment. The NPV gives you the direct measure of the dollar contribution of your investors. Managers can also use it to evaluate different capital projects. Thus, they can determine the present value of their investments’ projected returns.
In order to obtain this value, subtract the cost of the current value of your investment from the present value of your future income. If the returns are positive, you should go for the project. If the returns are negative, you should think otherwise. The returns could also be zero, a position that is only profitable if you are providing public goods or services.