How to do a simple NPV Calculation for your start-up business?
Net Present Value is a globally used investment appraisal technique that takes into account the time value of money in assessing the financial feasibility of an investment. NPV is the net gain or loss created as a result of investing in a project, hence it directly measures the impact on shareholder wealth, which is why most financial analysts prefer using this technique. We can arrive at the NPV after calculating the net discounted cash flows of a project over its life span.
Therefore, the formula for NPV could be set out as follows:
Net Present Value = Present Value of Cash inflows – Present Value of Cash outflows
Present value is the value of an expected income stream in the present, in contrast to some future value it will have when it has been invested at compound interest. In NPV calculation, we assess whether the present value of the expected net cashflow from the investment is a positive value, meaning, the cash inflow is greater than the expected cash outflow.
It is necessary to take only relevant cashflows when performing an NPV calculation. Relevant cashflows are the cashflows which occur in the future as a direct result of the investment. Therefore, sunk costs such as cost of market research or non-cash elements such as depreciation are excluded from the NPV calculation.
To calculate the present value of a future cashflow, the relevant cashflow figures have to be discounted using a given cost of capital rate.
Present Value of Cashflow = Cashflow x Discount Factor of the Cost of Capital
Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk. Thus, the cost of capital is the rate of return required to persuade the investor to make a given investment.
It may be difficult to determine the most accurate cost of capital value since it involves a lot of assumptions and professional judgement but it is essential to incorporate all the risk factors into the cost of capital figure and it should represent the current market conditions.
Often, investors use the weighted average of a firm’s cost of debt and cost of equity to arrive at the cost of capital value. For example, consider an enterprise with a capital structure consisting of 70% equity and 30% debt; its cost of equity is 10% and the after-tax cost of debt is 7%.
Therefore, its weighted average cost of capital would be:
(0.7 x 10%) + (0.3 x 7%) = 9.1%
Discount factor of a given cost of capital can be calculated as follows:
( 1 + r )-n where,
r = cost of capital
n = number of time periods
For example, the discount factor for a cost of capital of 10% on the third year would be calculated in the following manner.
( 1 + 0.1 )-3 = 0.751
Having identified and understood each element of the NPV calculation, now you can apply the relevant cashflow values into the given Net Present Value formulae to calculate the Net Present Value of your investment.
The decision criteria of NPV technique is pretty straightforward; the investment is accepted only if it generates a cash surplus for the investor in present value terms. Therefore,
- if the NPV of a project is positive, then the project is accepted.
- if the NPV of a project is negative, then the project is rejected.
We hope now you have a clear understanding of the applicability of NPV and that you are able to apply it on your own to your future investment projects.