If you’re looking for ways to help make better business decisions, try calculating the Net Present Value (NPV). NPV is a helpful analysis tool to incorporate into your business, because it helps you determine if an investment or new project is worth pursuing. It compares the present value of cash inflows and outflows for a given amount of time to help you evaluate whether or not the project should result in a profit or a loss.
Why Use NPV?
There may be times when you have ideas for new projects, but your business might be low on money. In these cases, you can use NPV to compare multiple projects on an apples-to-apples basis to help you choose the best one to pursue. The calculation helps you find the project with the greatest potential for being profitable. It can also help you avoid a project that may cost more than its potential earnings, which results in a loss. Using NPV can help you invest your time and money wisely to make the best use of it.
What Is NPV Based On?
This calculation takes into account the time value of money. At its core, the time value of money assumes that having $1 today is more valuable than having $1 in the future, factoring in elements like interest and inflation. The exact formula for NPV is a bit complicated. It takes into account cash flows received at specific periods of time, total initial investment costs, the total number of time periods, and an assumed discount rate, usually based on a standard interest rate.
Example of Net Present Value
Here is an example of NPV, with some slight rounding to help with simplicity:
Your business has a project idea that requires an investment of $50,000. You expect the investment to last around three years and create $20,000 in the first year, $30,000 in the second year and $40,000 in the final year. The assumed discount rate is 8%. Based on this information, the present value for each of the year’s cash flow is:
Year 1: $20,000 / (1.08) approximately equals $18,500
Year 2: $30,000 / (1.08)^2 approximately equals $25,700
Year 3: $40,000 / (1.08)^3 approximately equals $31,800
Therefore, the NPV equals:
NPV = $18,500 + $25,700 + $31,800 – $50,000 = $26,000
If your answer is a positive number, you can assume the project is a profitable idea. In other words, the project should generate more earnings than it costs you. If your answer is negative, it means the project may result in a loss. The higher the number, the greater the potential profitability of the idea. Finding a project with a high NPV likely gives you the best option to pursue.
As you can see, NPV is a handy financial tool used by analysts every day. As a small business owner, you can benefit by using NPV to determine if a project is worth it. While it may seem daunting at first, a little bit of practice is sure to make you more confident using the NPV formula. Keep your books accurate and up to date automatically. Change the way you manage your finances now.