Net Present Value Definition and example
Net present value (NPV) is the capital budgeting formula that is used to measure the difference between the present value of cash inflows and outflows of potential investment or project.
In other words, the net present value is the amount of money that an investment generated by comparing with cost adjusted for the time value of money.
The concept of NPV is the most important because the worth of 1 dollar at present is greater than the future time of 1 dollar because of the interest and opportunity cost.
For the making of the investment decision sophisticated investors and the management of the company use the discount cash flow metrics or use the present value analysis.
The formula for the net present value
The formula of Net present value (NPV) is complicated because for the calculation of this sum of all the future cash flow from investment, discount them at a discount rate, and then subtract the initial investment from this.
NPV Formula component
- Ct represents net cash flow for the period.
- CO represents an initial investment
- r represents the discount rate
- t represents the number of periods in the above formula.
For a better understanding of the NPV, we use the nonmathematical equation.
NPV= Present value of future cash flows – Present value of the initial investment cost
From the above equation, we can say that NPV is equal to the difference of PV of initial investment and PV of the money which the investment will make in future.
Management uses the net present value of the potential project of the company, expansion of business, new equipment to evaluate what option is the best and in the future which is the best path which company takes.
Now we take the example of the manufacturing company which wants to expand its business But for this company does not have enough equipment. In this case, the company use the Net price value (NPV) calculator to find that the machinery purchasing is a good investment or not. It can get by comparing the amount of the cash inflows new machinery generating with the initial cost of the machinery.
If the NPV give a positive number it means that the future cash flow of the project is greater than the initial cost. So the company gets money on its investment. But if the NPV result in a negative number it means that the future cash flow of the project is less than the cost of machinery on which purchasing company invests.
If the number in the result of NPV is positive and much high then the company earn much more than the initial cost of the machinery. This ratio can be used to evaluate to project to find that which is the best project for the investment.
Net Present Value Example
Tom has a construction company that builds small buildings. He wants to expand his business and want to construct the large building for which he needs the crane. The price of the crane is 100,000 dollars. He estimates that he can earn each year 20,000 dollars from this crane for the next 10 years.
So after 10 years, he will get 20,000 dollars money after 10 years from his 100,000 dollars investment. For the time value of money to adjust 200,000 dollars is not discounted.
If the interest rate is 10% then the discounted cash flow from the crane will be 122,891.34. Now we calculate the NPV for the investment of Tom.
Net Present Value
$22891.34 = $122,891.34 – $100,000
From the above result, it is clear that Tom is not 100,000 dollars because when the time value of money adjusts then he makes only 22891.34 dollars. The above result is good because it is in positive number and Tom makes money on their investment.
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