Net Present Value Defined

The NPV of a project or investment reflects the degree to which cash inflow, or
revenue, equals or exceeds the amount of investment capital required to fund it.
When assessing multiple projects, businesses use NPV as a way of comparing
their relative profitability to ensure that only the most lucrative ventures are
pursued. A higher NPV indicates that the project or investment is more profitable.
To calculate NPV, the estimated cash outflow and inflow for each period must be
established, as well as the expected discount rate. Though the exact figures can
only be known after completion, fair estimates can be made by looking at the
performance of similar projects or investments.
NPV = {Net Period Cash Flow/(1+R)^T} - Initial Investment
Where R is the rate of return and T is the number of time periods.

A Brief Example of NPV

Assume a company wants to analyse the predicted profitability of a project that
requires an initial outlay of $10,000. Over the course of three years, the project
is expected to generate revenues of $2,000, $7,000 and $11,000, respectively.
The anticipated discount rate is 4.5%. At first glance, it seems the returns are
nearly double the investment. However, a dollar earned in three years is not as
valuable as a dollar earned today, so the company's accountant calculates the
NPV as follows to determine profitability while accounting for the discounted time
value of the projected revenues:
NPV = {$2,000/(1+.045)^1} + {$7,000/(1+.045)^2} + {$11,000/(1+.045)^3} $10,000
= $1,913.88 + $6,410.11 + $9,639.26 - $10,000
= $7,963.25

Calculating NPV in Excel

While calculating NPV for short-term projects with simple cash flows is fairly
straightforward, many projects require additional injections of capital after
inception and take years to complete. In these cases, calculating NPV by hand
becomes inefficient. However, the NPV of any investment or project can easily be
calculated using Microsoft Excel, given that cash flows are evenly spaced over
time.

First, enter the anticipated discount rate into cell A1. Next, input all cash flows
sequentially into adjacent cells, entering any outflow values as negative

numbers. For example, a project with a single initial investment that is expected
to generate returns over the course of three years will have four entries in cells
A2 through A5. Excel assumes all flows occur at the end of each period.
Therefore, if the initial investment occurs at project inception rather than at the
end of the first period, then this figure will need to be added to the NPV function
separately and not included in the function itself.
If the initial investment occurs at the end of the first period, as the program
assumes, enter the formula "=NPV(A1,A2,A3,A4,A5)" into cell A6 to render the
NPV for this project.
If the initial investment occurs at the beginning of the first period instead, enter
the formula "=NPV(A1,A3,A4,A5)+A2" to account for that initial outlay.