Simplifying Net Present Value (NPV)

Whether you’re helping a client build a business case or, launching a strategic project, chances are you’ll need to get your hands dirty by calculating the Net Present Value (NPV) of their investment.

The concept behind NPV is simple: cash in-hand today is more valuable than cash received next year, the year after that and so on. That’s because a company can invest that “in-hand” money today and make a return, but they can’t do squat with future cash flows because they don’t have them yet!

To justify funding a project, its NPV needs to be positive. That means, when added up, the difference between the present value of all cash inflows and outflows is greater than zero. Anything break-even or negative is a loser (typically).

Formula: NPV is calculated by totaling the present value of the expected cash flows (benefits) and subtracting the initial outflow (investment):

NPV=-C_0+\frac{C_1}{1+i}+\frac{C_2}{(1+i)^2}+\dots+\frac{C_T}{(1+i)^T}

C is the cash flow, T is the time of the cash flow, and i is the desired rate of return or discount rate.

Example: Let’s say you (or,your customer) are interested in investing in a new eCommerce website to generate sales online and it will cost $300,000 up-front.

Assuming a discount rate, i, of 10% and sales forecasts for periods 1-3 in the table below, we arrive at the NPV shown below:

eCommerce Website Project
Period Cash Flow Present Value
0 -$300,000 -$300,000
1 $50,000 $45,454.55
2 $150,000 $123,966.94
3 $275,000 $206,611.57
Net Present Value $76,033.06

It’s that easy. This project has an NPV of $76,033 and is likely to be approved.

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