Net Present Value (NPV) is a time series of Cash Flow of both incoming and outgoing money. 'Net' Present Value is the sum of all Present Value. It is a typical method to calculate time-value of the money for the appraisal of long term projects. Equation: (1/(1+Discount rate)^year)) Discount rate = Firm's average cost in capital or capital needed for the project could return id invested on something else. (usually given in questions) NPV indicates to a company how much value that project is contributing to the company. When we get positive numbers for our NPV, it shows that the project is in the status of discounted cash INFLOW in the year ending as indicated when you calculate. Let's do an example. Supposed you are making a decision with regards to launching a product. Your finance department calculated 2 discount rate at 15 and 20% respectively. Under which scenario will you go ahead with the project? Discount rate @ 20% | |||||
| Year | Cashflow | Discount Factor (1/(1+Discount rate)^year)) | Discounted Cashflow | ||
| 0 | -$17,500,000.00 | 1/(1.2)^0 = 1 | -$17,500,000.00 | ||
| 1 | $6,100,000.00 | 1/(1.2)^1 = 0.833 | $5,081,300.000 | ||
| 2 | $7,400,000.00 | 1/(1.2)^2 = 0.694 | $5,135,600.000 | ||
| 3 | $7,000,000.00 | 1/(1.2)^3 = 0.579 | $4,053,000.000 | ||
| 4 | $5,500,000.00 | 1/(1.2)^4 = 0.482 | $2,651,000.000 | ||
| Net Present Value | -$579,100.00 | ||||
| Discount rate @ 15% | |||||
| Year | Cashflow | Discount Factor (1/(1+Discount rate)^year)) | Discounted Cashflow | ||
| 0 | -$17,500,000.00 | 1/(1.15)^0 = 1 | -$17,500,000.00 | ||
| 1 | $6,100,000.00 | 1/(1.15)^1 = 0.870 | $5,307,000.000 | ||
| 2 | $7,400,000.00 | 1/(1.15)^2 = 0.756 | $5,594,400.000 | ||
| 3 | $7,000,000.00 | 1/(1.15)^3 = 0.658 | $4,606,000.000 | ||
| 4 | $5,500,000.00 | 1/(1.15)^4 = 0.572 | $3,146,000.000 | ||
| Net Present Value | $1,153,400.00 | ||||
Note: Any cash flow that is within the first 12 months will NOT be discounted.
Answer: Discount rate @ 15%
Therefore, NPV is a good indicator to gauge if the project is adding on to your existing portfolio of products. It also indicates the viability of your project. The money that is incoming as discounted, which accounts for time-value of money and it is a good indicator for decision making analysis. Think marketing is just theory? Think again :)
