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):
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:
|Period||Cash Flow||Present Value|
|Net Present Value||$76,033.06|
It’s that easy. This project has an NPV of $76,033 and is likely to be approved.