How to calculate NPV
As a small business owner, making the right financial decisions is vital for your company's success. Fortunately, several finance methods and models exist that can help you evaluate your options and make informed choices.
One excellent finance method that can help you make profitable business decisions is net present value (NPV). NPV calculates the profitability of a project by comparing the present value of cash inflows and outflows. It's an important financial tool that helps determine if a particular project is a worthwhile investment for your business.
This article offers in-depth insights and practical examples using NPV, empowering you to make informed decisions that enhance your business's bottom line.
What is net present value (NPV)?
NPV is a formula that allows you to calculate a project's value over its entire lifespan, adjusted to reflect today's worth. It's a quantitative tool that considers your project's cash inflows, cash outflows, and the time value of money to assess whether a business venture is financially viable.
Simply put, NPV is a capital budgeting metric that evaluates the profitability of a project or investment.
Why use net present value?
When your business is short on funds but you have multiple project ideas, NPV helps you objectively compare these options to determine which one offers the most potential profit. This calculation identifies the project with the highest likelihood of success, while helping you avoid those that may lead to financial losses.
By using NPV, you can allocate your resources more effectively.
What is net present value based on?
NPV calculations rely on the time value of money, which posits that $1 today is more valuable than $1 in the future due to factors like interest and inflation. The NPV formula is somewhat complex, as it accounts for cash flows received at specific intervals, initial investment costs, the number of periods, and an assumed discount rate, typically based on prevailing interest rates.
How do you calculate NPV?
The NPV formula incorporates four key variables:
- C(t) = Net cash flow during period t
- C(0) = Total initial investment
- r = Discount rate
- t = Number of time periods
And looks like this:
As an example, suppose you're evaluating a project expected to last five years (t). The anticipated cash inflows C(t) for each year are:
- Year 1: $5,000
- Year 2: $7,000
- Year 3: $10,000
- Year 4: $12,000
- Year 5: $15,000
With a discount rate (r) of 7% and an initial project cost of $25,000 C(0), the discounted cash flows for each year are:
- Year 1: $5,000 / (1 + 7%)^1 = $4,672.90
- Year 2: $7,000 / (1 + 7%)^2 = $6,114.07
- Year 3: $10,000 / (1 + 7%)^3 = $8,162.98
- Year 4: $12,000 / (1 + 7%)^4 = $9,154.74
- Year 5: $15,000 / (1 + 7%)^5 = $10,694.79
Adding these cash flows totals $38,799.48. Therefore, the NPV for your project is:
NPV = $38,799.48 – $25,000 = $13,799.48
How to compare business projects using NPV
Since NPV calculates the value of all future potential cash flow for your business — whether positive or negative — the most favourable projects are those with an NPV greater than $0. A positive NPV indicates that a project’s earnings exceed its initial costs, implying profitability.
Conversely, a negative NPV suggests the project won’t generate enough cash flow to cover its initial investment, leading to a loss.
Consider an NPV analysis of five projects with the following results:
- Project 1: NPV = $10,000
- Project 2: NPV = $3,300
- Project 3: NPV = ($2,500)
- Project 4: NPV = $0
- Project 5: NPV = $4,000
In this scenario, projects 1, 2, and 5 are clearly profitable. Prioritizing the project with the highest NPV is recommended, but if your budget allows, pursuing all three profitable projects is even better. Projects 3 and 4 are not advisable.
As a small business owner, making informed financial decisions is critical. Tools like the QuickBooks Self-Employed app can help freelancers, contractors, and sole proprietors track and manage business finances on the go. Download the app today to stay on top of your financial health.
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