From the course: Investment Evaluation

The net present value equation - Microsoft Excel Tutorial

From the course: Investment Evaluation

Start my 1-month free trial Buy for my team

The net present value equation

"

- Net present value or NPV is one of the most valuable decision making metrics you can use to decide whether investment or project is worth your time or money. NPV builds off the concept of discounted cash flows. Here is the fancy equation with all its Greek symbols and stuff. However, if you strip that down and get to the root of it, it's basically DCF with one extra component. The equation says that you add up all the present values of all future cash inflows and then subtract the sum of the present value of all future cash outflows. These inflows and outflows are simply revenues and costs. What makes NPV so special is that you can continue to calculate NPV over the duration of a lifetime of a project. Obviously, the project's NPV is likely to decrease over time. It has less life and fewer unrealized cash flows because it has already generated that revenue for you. Look at the two equations again for DCF and NPV. To reiterate, NPV is simply DCF less the initial cash investment. Keep this one takeaway in mind that differentiates between these techniques. DCF tells you the present value of the cash flows expected from your model, basically the ongoing cash flow to be generated from your investment. NPV tells you the net return after the accounting of overhead cost. So, if the NPV for a project is positive, that's a good thing. You wanna take that investment or project. If it's negative, you probably shouldn't take on that project 'cause you're more than likely going to lose money. I'm putting air quotes around lose money because of opportunity cost. If the NPV on a project is negative, you're more than likely gonna get more money out of a project that has a higher NPV or from something like the stock market on average. Any investment will produce a negative NPV if the applied discount rate is high enough. So, it makes sense to double-check the estimated costs to look for opportunities to economize, to review the sources of revenue, to seek potential enhancements, and to revisit the assumed discount rate. What if the NPV is zero? Remember, NPV is a measure of wealth creation relative to the discount rate. So, a negative or zero NPV does not indicate no value. Rather, a zero NPV means that the investment earns a rate of return equal to that of the discount rate. If you discount cash flows using a 6% discount rate and produce a $0 NPV, then the analysis indicates that your investment would earn a 6% rate of return. All right, enough with all this conceptual stuff. Take a deep breath. Let's dig into the math and do some calculations.

Inhalt