How is a Net Present Value Formula Calculated?

by Jayne Thompson - Updated March 05, 2018
accounting

There’s a saying in finance that a dollar today is worth more than a dollar tomorrow. That’s because money depreciates in value over time due to variables such as inflation. When calculating the current value of revenue that will be earned down the road, a business must account for the time value of money. Net Present Value is a method of comparing potential projects based on their projected cash inflows in the future.

Tips

  • There are two formulas for calculating Net Present Value depending on whether a project generates returns in equal or unequal amounts over the project period.

How to Calculate Net Present Value

Calculating NPV is a two-step process. First, you need to estimate the net cash flows from the project over its life. Net cash flow is the sum of the revenues generated by the project during a specific period minus cash outflows during the same period. Then, you need to discount those cash flows at a target rate of return. Most organizations use the weighted average cost of capital as the required rate. There are two different formulas for calculating NPV depending on whether your net cash flows stay the same across the different project periods, or whether your revenue fluctuates.

Two Formulas for Net Present Value

When revenues are generated evenly across the project, the NPV formula is:

NPV = R x {(1 - (1 + i)-n) / i} − Initial Investment.

When the project generates cash inflows at varying rates, the formula is:

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NPV = (R for Period 1 / (1 + i)1) + (R for Period 2 / (1 + i)2) ... (R for Period x / (1 + i)x) − Initial Investment.

Where:

  • R is the expected net cash flow in each period.
  • i is the required rate of return.
  • n is the length of the project, that is, the number of periods over which the project will generate income.

Why You Need to Know Net Present Value

NPV is an essential tool for corporate budgeting. It shows how much money you could earn or lose from a project while taking into account the time value of money. Generally, any project with a positive NPV is returning a profit; A project that returns a negative NPV will run at a loss. When you’re evaluating multiple potential projects, it makes sense to accept the project with the highest NPV since this project will return the greatest profit.

Worked Example

Suppose a company is weighing up two potential projects. Project A requires an upfront investment of $50,000 and is expected to generate first, second and third-year returns of $20,000, $25,000 and $28,000 respectively. The required rate of return is 10 percent. Since the revenues are uneven, the company must use the second NPV formula:

NPV = {$20,000 / (1 + 0.10)1} + {$25,000 / (1 + 0.10)2} + {$28,000 / (1 + 0.10)3} − $50,000
NPV = $16,529 + $20,661 + $21,037 − $50,000
NPV = $8,227

Project B will generate $35,000 per year for two years and also requires a $50,000 investment. Since each period produces equal revenues, the company must use the first NPV formula. Assuming the target rate of return remains the same:

NPV = $35,000 x {(1 - (1 + 0.10)-2) / 0.10} − $50,000
NPV = $60,760 − $50,000
NPV = $10,760

In this example, Project B has a higher NPV and is more profitable even though, on the face of it, Project A generates more revenues.

Calculating Net Present Value in Excel

There are two ways to calculate NPV in Excel. The first is to plug in one of the formulas described above; the second is to use the built-in NPV function. However, since the built-in formula will not account for a project’s initial cash outlay, most organizations find it easier to use the first approach. This has the added advantage of providing a transparent and auditable number trail that you don’t always get when the figures are hidden within a complex formula. There are plenty of Excel tutorials available online to help you run the numbers.

About the Author

A former corporate real estate lawyer, Jayne Thompson writes about law, business and personal finance, drawing on 17 years’ experience in the legal sector. She holds a Bachelor of Law and Business from the University of Birmingham and a Masters in International Law from the University of East London. Find her at www.whiterosecopywriting.com.

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