Net Present Value helps us determine whether a project is profitable or not. It is one of the most widely used tools in the world of finance, particularly in project evaluation. NPV represents the value of future cash flows minus the initial investment of a project, discounted to present value using a discount rate.
How to calculate it?
To calculate Net Present Value (NPV), we must discount the project’s incoming cash flows (i.e., future net revenues) to their present value using the required rate of return, which in this case corresponds to the investment’s WACC (Weighted Average Cost of Capital). From these discounted cash flows, the present value of the outgoing cash flows, which corresponds to the project’s initial investment, is subtracted.
If the NPV is positive, it means the project is viable and profitable because the future cash flows, discounted to present value, exceed the initial investment and generate a return greater than the minimum required rate of return (WACC). In other words, the investment not only recovers its initial cost but also provides an additional surplus, representing a gain. Conversely, if the NPV is negative, it indicates that the project is not profitable, as the discounted future cash flows fail to cover the initial investment or meet the minimum expected return, implying a loss in value from undertaking the investment.
Net Present Value is calculated as follows:
Where:
FC𝑡 = Cash flow at time 𝑡.
𝑡 = Time period
r = Discount rate (WACC or required rate of return)
I0 = Initial investment.
Let’s analyze an investment project that requires an initial outlay of US$1,000,000. The applied discount rate (WACC) is 11% annually, and the projected net cash flows for the next four years are:
Year 1: US$300,000
Year 2: US$400,000
Year 3: US$400,000
Year 4: US$500,000
We will calculate the Net Present Value (NPV) to determine if the project is profitable.
The Excel formula would be as follows:
=VPN (11%, 300000,400000,400000,500000) – 1000000
Net Present Value helps us determine whether a project generates value by showing that the discounted future cash flows are sufficient to recover the initial investment and exceed the minimum expected return (WACC). It is a key tool for making informed and strategic investment decisions. Due to its ability to incorporate the time value of money and all relevant cash flows, NPV is a robust and widely used tool in the evaluation of investment projects.