How do you calculate npv?

Answer 1

NPV Definition

Net Present Value of an investment project is the difference of sum of discounted net cash flows and the initial cash outlay or our initial expense. We discount each of the net cash flows at the discount rate or the cost of capital.

NPV Calculation

Let me illustrate the whole process, say we are making a small investment of $1000 and expect four cash inflows in the amounts of $500, $400, $300 and $100 at the end of each of the next four periods (which may be months, quarters, or years). The cost of capital or our discount rate is 10%

Here is how we discount each of the cash flows

$500/(1+0.10)1 = $500/1.1 = $454.55

$400/(1+0.10)2 = $400/1.21 = $330.58

$300/(1+0.10)3 = $300/1.331 = $225.39

$100/(1+0.10)4 = $100/1.4641 = $68.30

Sum of Discounted Cash Flows = $454.55 + $330.58 + $225.39 + $68.30

Sum of Discounted Cash Flows = $1078.82

NPV = $1078.82 - $1,000

NPV = 78.82

Acceptance Criteria

Since our NPV results in $78.82 which is a positive figure, we will be inclined to invest money in this project.

Just to illustrate when we won't accept the project is illustrated below where we have appreciated the discount rate or our cost of capital to 15%. Let us see what effect the raising of discount rate has on NPV

$500/(1+0.15)1 = $500/1.15 = $434.78

$400/(1+0.15)2 = $400/1.3225 = $302.46

$300/(1+0.15)3 = $300/1.520875 = $197.25

$100/(1+0.15)4 = $100/1.74900625= $57.17

Sum of Discounted Cash Flows = $434.78 + $302.46 + $197.25 + $57.17

Sum of Discounted Cash Flows = $991.66

NPV = $991.66 - $1,000

NPV = -$8.34

It turns out that at the cost of capital of 15% our NPV results in a negative territory thus highlighting that we will lose money if we put our money into this investment