**What is NPV?

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Before I show you how to calculate the net present value or NPV, let me briefly explain what it is. Simply put, it's a way to decide whether or not to invest in a project by looking at the projected cash inflows and outflows. 2 **How NPV helps you decide** Now that you understand what NPV is, let me tell you how you use it to decide if a project is a go or not. Simple: a) If the value of NPV is greater than 0, then the project is a go! In other words, it's profitable and worth the risk. b) If the value of NPV is less than 0, then the project isn't worth the risk and is a nogo. In other words, you'll pass on it. So NPV takes risk and reward into consideration, which is why we use it in the world of corporate finance and capital budgeting. Sponsored Links

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AmericanMachinist.com 3 **Example** In order for us to calculate NPV, let's use the following example. Suppose we'd like to make 10% profit on a 3 year project that will initially cost us $10,000. a) In the first year, we expect to make $3000 b) In the second year, we expect to make $4300 c) In the third year, we expect to make $5800 4 **Calculation step 1** Right now, the project is going to cost us $10,000. So we won't be making any money until at least a year from now. What we need to do is calculate how much each of those future profit amounts will be worth right here, today. This means we need to calculate the present value of each of those 3 cash flows we'll be getting over the next three years. In other words, ask yourself: a) How much is that $3000 one year from now worth today? b) How much is that $4300 two years from now worth today? c) How much is that 5800 worth three years from now worth today?

The answers to each of these three questions is the present value for that particular cash inflow. 5 **Calculation step 2** In my example, I said I'd like to make a 10% profit. This is important because it's the bare minimum we'll need to make in order to say yes to this project. In corporate finance, we call this rate our required rate of return (ROR). To get our present values, we use this ROR! In other words, we ask ourselves: a) Earning 10%, $3000 one year from today would be worth how much right now? b) Earning 10%, $4300 two years from today would be worth how much right now? c) Earning 10%, $5800 three years from today would be worth how much right now? 6

**Calculation step 3** Let's assume you're using present value tables to get your answers. a) You'll go over to 10% and down to 1 in the time period column to get your interest factor. It'll be something like 0.9091. Multiply this factor by the $3000 we'll be getting in the first year, and it gives us a present value of $2727.27. b) Do the same thing for the $4300 we'll be getting in the second year. This time, you'll go over to 10% and down to 2 in the time period column to get your interest factor. That'll be 0.8264. Multiply this by the $4300 to get a present value of $3,553.72 c) Do the same thing for the $5800 we'll be getting in the third year. This time, you'll go over to 10% and down to 3 in the time period column to get your interest factor. That'll be 0.7513. Multiply this by the $5800 to get a present value of $4,357.63 7 **Calculation step 4** Our next step is to add up all those present values we just calculated in step 6. Adding $2,727.27 + $3,553.72 + $4,357.63 gives us $10,638.62. 8 **Final step** The last thing we need to do is subtract our original investment in the project from the result in step 7. Doing this gives us $10,638.62 - $10,000 or $638.62. This is our NPV!

So is this project a go? Well remember what I said at the very beginning. If NPV is bigger than 0, then it's a go. Well $638.62 is clearly larger than 0 which means the project is worth it and is a go! 9

**Using a financial calculator to get your answer** In my example, I used present value tables to calculate NPV. You can also do it using a financial calculator. a) To get the present value of that $3000 we'll be getting in the first year, you'll enter 3000 as your fugure value (FV). Why? Because that money won't be received until a year from now. Then you'll enter 1 for the time period (NPER or N key) on the calculator. This means 1 year from now. Next, you'll enter 10% by using the %i key for your rate because that's what you'd like to earn. You'll now compute the present value (PV)by pressing some combination of keys on your calculator. Which ones that'll be will vary. For instance, on mine I press CPT for compute and PV for present value. Lastly, you'll store that value in memory. This is so you can add all those present values from the other years together. TIP: On some calculators, you enter the rate as 10%. On others, you type .10. Be sure you enter it correctly or your answer will be wrong! Doing this calculation will give you the same answers as we got in step 6. b) Do the same thing for the $4300 we'll be getting in the second year. But this time, you'll enter 2 for your time period (N or NPER key) and 4300 as your future value (FV). Why 2 for the time period? Because you won't get that money until 2 years from now. Now compute your present value and add it to your previous one in part (a). c) Do the same thing for the $5800 we'll be getting in the third year. But this time, you'll enter 3 for your time period (N or NPER key) and 5800 as your future value (FV). Why 3 for the time period? Because you won't get that money until 3 years from now. Now compute your present value and add it to your previous one in part (b). You've calculated the present values of those 3 cash inflows you've gotten from the project or investment and have added them all together. The final step is to subtract the original investment, which is $10,000 in my example. So adding all the present values together will give you the same answer as in step 7. And subtracting the original $10,000 investment will give you the same result in step 8. So your NPV will be $638.62 in both cases

Read more: How to calculate net present value (NPV) | eHow.com http://www.ehow.com/how_2187130_calculate-net-present-value-npv.html#ixzz1zqEyuOnC