The calculation of the net present value (NPV) is a budgeting technique that equates the discounted cash flows against the initial investment. The mathematical formula is:
$latex NPV = \sum_{t=1}^{n}\frac{FV_{t}}{(1 + k)^{t}} – I$
Where:
FV = Future cost of the cash inflows,
I = Initial Investment
k = Discount rate equal to the owner’s cost of capital
I will demonstrate with an example. Let’s say a project represents a series of cash flows that looks like this:
Year | Cash Inflows | Present Value (at 10% discount rate) |
---|---|---|
1 | $1,000 | $909 |
2 | $2,000 | $1,653 |
3 | $2,000 | $1,503 |
4 | $5,000 | $3,415 |
5 | $2,000 | $1,242 |
Present Value of cash inflows (Total) | $8,722 | |
Less investment | $10,000 | |
Net Present Value | ($1,278) |
In this hypothetical example, each of the cash flows discounted to the present will not recover the initial investment, and this investment should not be made.
- If the Net Present Value is greater than zero, accept the project.
- If the Net Present Value is less than zero, decline the project.