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 is worth pursuing.
For example, there are times when you have ideas for new projects, but your business is 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.
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.
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 percent. 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
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.