Calculate the net present value of a series of cashflows

What is the net present value (NPV)?

Money has time value associated with it. The value of income received (from investments, a business project etc) in the future has a lower value than the same amount received today. In other words, the value of money today is more than the value of money in the future. The net present value (NPV) is the sum of the present value of the cash outflow and all expected cash inflows. It is calculated by discounting the cashflows with a discount rate. The larger the discount rate, the lower the value of money in the future is. If the NPV is positive, the series of cashflows (an investment with one or more cash inflows) is profitable. If a project or investment has a negative NPV, it means that the investment has lost money. The NPV is affected by the cashflows and the discount rate. If the NPV of two projects/investments is equal, then the duration should be looked at as well since realistically, a project which is profitable in a shorter period of time is better.

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When should I use NPV?

In the financial sense, NPV is used when determining the profitability of a financial investment such as an investment into a project or machine. Calculating the NPV considers the time value of money and in some way it also considers risk if the discount factor is selected appropriately.

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NPV can also be used to compare different available investments in order to quickly identify all profitable or non-profitable investments.

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How is NPV estimated?

The formula that can be used to estimate the NPV along with an explanation of the terms is provided above. This formula assumes at least one negative cashflow and equally spaced cashflows (e.g. yearly cashflows)

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How should the discount rate be selected?

The discount rate is a user-defined input that is needed to calculate the NPV. There are different ways to select the discount rate. This depends on the preferences of the decision maker. Changing the discount rate can influence decisions, .e.g.increasing the discount rate, requires investments to be more profitable in order to be selected. Let us look at 2 base cases

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1. If risk is neglected and the discount rate is set to be equal to the expected inflation rate, then the investments are compared such that their returns need to match or beat inflation in order to be considered (An investment with an NPV less than 0 would not be able to beat inflation)

2. If inflation is neglected and the discount rate is set equal to the risk-free investment rate, then the investments are evaluated to see if they can meet or beat the returns from a risk-free investment (An investment with an NPV less than or equal to 0 would not be selected as the risk-free investment would offer equal or better returns at no risk)

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Usually the discount rate is selected such that aspects such as risk or inflation is accounted for. A discount rate of 8% means that the project needs to make at least 8% in order for it to be viewed as profitable by the investor.

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What is an example of NPV?

Assume an investment of ₹10,00,000 invested initially that pays out  ₹50,000 to the investor for 4 years and is then sold in the 5th year for a price of ₹15,00,000. In such a case, the series of cashflows in would be -10,00,000 | 50,000 | 50,000 | 50,000 | 50,000 | 15,00,000. The NPV for such an investment would be ₹89,875.26 assuming that the annual payouts of ₹50,000 are not reinvested in some way.

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Should the payout in the last year be only ₹10,00,000 instead of ₹15,00,000, then the NPV would reduce to minus ₹2,20,585.4 and would imply that the investment is not profitable although the net income was ₹12,00,000 on an investment of ₹10,00,000. The investor would have definitely made money, but on the whole the investment does not fulfil the NPV condition as the NPV is negative. If there would have existed another investment with a larger or positive NPV, then that would be the better choice.

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Note:

If an investment fulfills the NPV criteria, it does not automatically mean it is a good investment. If we compare investment option A and B below, we see that the NPV is equal but investment A starts paying back returns sooner and breaks even faster. If the risk of both investments is equal, then investors would usually prefer option B as the breakven is sooner and the investor can use the larger payout from investment B in year 1 to invest elesewhere. If an investor perceives the risk of B to be significantly larger than that of A, then selecting option A could make sense. If a third option, investment C is considered, then it has an even larger NPV. If risk is equal to that of options A and B, then C would be preferable, However, should there be liquidity needs in years 1 or 2, then C would not be as suitable, although it it a better investment.Therefore, while comparing investments, it is important to look at other factors such as risk, the nature of the payouts, the breakeven point, liquidity constraints, liquidity requirements, investment objectives etc.

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Investment option A with an NPV of ₹50,000; breakeven is somewhere between year 2 and 3

Investment: 5,00,000

Cashflow year 1: 1,00,000

Cashflow year 2: 2,00,000

Cashflow year 3: 3,91,050

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Investment option B with an NPV of ₹50,000; breakeven is somewhere between year 1 and 2

Investment: 5,00,000

Cashflow year 1: 5,00,000

Cashflow year 2: 1,00,000

Cashflow year 3: 17,050

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Investment option C with an NPV of ₹60,000; breakeven is somewhere in year 3

Investment: 5,00,000

Cashflow year 1: 0

Cashflow year 2: 0

Cashflow year 3: 7,45,360

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Why is this NPV calculator useful?

This NPV calculator is useful as it can help with project planning and/or investment planning. It's also a good way for beginners and professionals alike to estimate the profitability from a series of investments and to make better decisions.

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How do I use this NPV calculator?

Instructions to use this NPV calculator are provided above.