4 Ways To Calculate Npv

For example, let’s imagine that you operate a small lemonade stand. You are considering buying an electric juicer for your business which will save you time and effort compared to juicing the lemons by hand. If the juicer costs $100, then that $100 is your initial investment.

In our lemonade stand example, let’s say that you’ve researched the juicer you intend to buy online. According to most reviews, the juicer works great, but usually breaks after about 3 years. In this case, you’ll use 3 years as the time period in your NPV calculation to determine whether the juicer will pay for itself before it’s likely to break.

Let’s continue with our lemonade stand example. Based on your past performance and your best future estimates, you assume that implementing the $100 juicer will bring in an extra $50 the first year, $40 the second year, and $30 the third year by reducing the time your employees need to spend juicing (and thus saving you money on wages). In this case, your expected cash inflows are: $50 in year 1, $40 in year 2, and $30 in year 3.

In corporate finance, a firm’s weighted-average cost of capital is often used to determine the discount rate. In simpler situations, you can usually just use the return rate on a savings account, stock investment, etc. that you might put your money in instead of making the investment you’re analyzing. In the lemonade stand example, let’s say that if you don’t purchase the juicer, you’ll invest the money in the stock market, where you feel confident that you can earn 4% annually on your money. In this case, 0. 04’ (4% expressed as a decimal) is the discount rate we’ll use in our calculation.

In the lemonade example, you’re analyzing 3 years, so you’ll need to use your formula 3 times. Calculate your yearly discounted cash flows as follows: Year One: 50 / (1 + 0. 04)1 = 50 / (1 . 04) = $48. 08 Year Two: 40 / (1 +0. 04)2 = 40 / 1. 082 = $36. 98 Year Three: 30 / (1 +0. 04)3 = 30 / 1. 125 = $26. 67

For the lemonade stand example, the final projected NPV value of the juicer would be: 48. 08 + 36. 98 + 26. 67 - 100 = $11. 73

In general, if the NPV for your investment is a positive number, then your investment will be more profitable than putting the money in your alternate investment and you should accept it. If the NPV is negative, your money is better invested elsewhere, and your proposed investment should be rejected. Note that these are generalities—in the real world, much more usually goes into the process of determining whether a certain investment is a wise idea. [7] X Research source In the lemonade stand example, the NPV is $11. 73. Since this is positive, you’ll probably decide to buy the juicer. Note that this doesn’t mean that the electric juicer only made you $11. 73. In fact, this means that the juicer made you the required return rate of 4% annually, plus an additional $11. 73 on top of that. In other words, it’s $11. 73 more profitable than your alternative investment.

For example, imagine if you’re hoping to make $2000 over 10 years, with a rate of return of 3%. The present value of this amount of money would be 2000/(1+. 03)10=1488. 18783{\displaystyle 2000/(1+. 03)^{10}=1488. 18783}, or about $1488. 19.

For example, say you need to invest $150 in a piece of equipment for your home business, then pay $50 in maintenance on it every 5 years. Your cash outflow for a period of 10 years would be $150 + $50 + $50 = $250.

If your PV is $1488. 19 and you expect your cash outflow to be $250, then your NPV = $1488. 19 - $250 = $1238. 19.

For instance, let’s say that we have three investment opportunities. One has an NPV of $150, one has an NPV of $45, and one has an NPV of -$10. In this situation, we’d pursue the $150 investment first because it has the greatest NPV. If we have enough resources, we’d pursue the $45 investment second because it’s less valuable. We wouldn’t pursue the -$10 investment at all because, with a negative NPV, it will make you less money than investing in an alternative with a similar level of risk.

For instance, let’s say we want to know how much $1,000 will be worth in five years. If we know that, at bare minimum, we can get a return rate of 2% on this money, we’ll use 0. 02 for i, 5 for t, and 1,000 for PV and solve for FV as follows: 1,000 = FV / (1+0. 02)5 1,000 = FV / (1. 02)5 1,000 = FV / 1. 104 1,000 × 1. 104 = FV = $1,104.