How To Calculate NPV
Question
After calculating NPV the present value of each of the cash flows ____________ significantly.
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Hi, my name is Grant Hobson. I've been a finance analyst for the last six years. Today I am going to run you through some financial performance methods as well as some investment appraisal techniques. How to calculate net present value? Net present value is a great tool for analyzing projects because it takes into consideration the time value of money. The time value of money is a simple concept in that 100 pounds today will not be worth 100 pounds 3 years down the line. Therefore, when looking at the cash flow that a project generates, you want to analyze these as the value they are worth to you today, as opposed to what they are worth in a few years time. The correct approach to calculating the net present value is by discounting all your future cash flows to the present value and summing them up together. If you have a positive net present value for your project, then it's generally deemed that you should accept the project. If you have a negative net present value, then the project should not go ahead. The calculation is a follows: each of your future cash flows is multiplied by a discount factor. The following formula shows now that the discount factor is calculated. The
stands for the interest rates and
for the number of periods. So as below, if your cost of capital is 10 %, then this forms the
in the equation; if it was 2 years down the line, then the period
would be 2; if it was 4 years down the line, then
would be 4. This will give you a discount factor for each period. If we look at this project below, it's a 4 year project. In year 0, this is today when the money is going out, cash flow is shown as a negative, because it's money you have spent on the project, it's 200,000 pounds outflow. The discount factor of this is 1, because in the discount formula, the
is 0 so your present value is 200,000 pounds; because it's money you have spent now. In each of the future years, a different cash flow is generated as the project moves forward. Each of these years has a different discount factor due to the period that the cash flow is incurred. You can get these discount factors from the present value tables that are available online. It's a quicker way to find the discount factor to use in the calculations. In terms of this equation; during year 1, the cash flow generated was 30,000 pounds. The discount factor is 0.909 because in one year's time this 30,000 pounds is worth less than it's worth today. So we need to find what this value is. Therefore, we multiply the 30,000 by the discount factor and we get a value of 27,270. This method is repeated for each of the three remaining years. You will see the present value of each of these cash flows reduces significantly as we go through the project. The sum of the project is -35180 pounds, now being negative, suggest that the project should not go ahead. So if we look at another project, we change some of the numbers within the project. The same outflow of 200,000, but in year one the investment performs better and we generate 50,000 pounds. In year two, it continues to increase up to 75,000 pounds. In year three and four, we generate 100,000 pounds. You can see the big increase in cash flow in future years means that the present value of this is now 50,800 pounds. It's positive and we would say that the project should go ahead.