How to Calculate Net Present Value
For example we are planning of starting a business of producing and selling pesticides. We can estimate the initial cost with reasonable accuracy because we know what we will need to buy to begin production. Would this be a good investment? It depends, whether its value exceeds its initial cost or not. In other words, does this project has a positive NPV?
As mostly companies are not routinely buy and sell in the market also there may be only few businesses who are in both production and selling business. Therefore is almost impossible to find out the exact market value of such investment. As a result, we will have to depend on other parameters to estimate the market value of our new business.
We first try to estimate the future cash flows we expect to generate from this business. Then we will calculate the present value of each cash flow. Once we have these estimates we can calculate the NPV as a difference between present value of these cash flows and the initial cost of starting this business.
Suppose cash revenue from this business will be $15000 per year and cost of running this business will be $6000. The business will be wind down in 6 years. Fixed assets will be worth $7000 as salvage at that time. Initial cost of launching this project is $20000 and discount rate on such new projects is 10%.
First, we will calculate the present value of all future cash flows at 10%. Net cash flows will be $15000 cash income less $6000 in cost for next 6 years. We will have $9000 net inflow along with a single lump-sum inflow of $7000 at the end of sixth year.
Year 0 1 2 3 4 5 6
Initial Investment -$20000
Cash Inflows $15000 $15000 $15000 $15000 $15000 $15000
Cash Outflows ($6000) ($6000) ($6000) ($6000) ($6000) ($6000)
Net Cash Inflows $9000 $9000 $9000 $9000 $9000 $9000
Salvage Value $7000
Net Cash Flows $9000 $9000 $9000 $9000 $9000 $16000
Present Value = $43148.66
When we compare present value of all future cash flows of this business to its initial estimated cost, we see that the Net Present Value is :
NPV= -$20000 + $43148.66
NPV = $23148.66
As NPV is positive therefore this is a good investment.