320 Part III: Financial Formulas

Figure 12-2: An initial investment returns positive future cash flows.

The NPV is negative, so this analysis indicates that buying the snowplow is not a good invest-
ment. Several factors that influence the result:

h First, I defined a “good investment” as one that returns 10% when I set the discount rate.
If you settle for a lesser return, the result might be satisfactory.
h The future cash flows are generally (but not always) estimates. In this case, the potential
plow owner assumes increasing revenue over the ten-year life of the equipment. Unless
he has a ten-year contract to plow snow that sets forth the exact amounts to be received,
the future cash flows are educated guesses at how much money he can make.
h Finally, the initial investment plays a significant role in the calculation. if you can get the
snowplow dealer to lower his price, the ten-year investment may prove worthwhile.

No initial investment
You can look at the snowplow example in a different way. In the previous example, you knew the
cost of the snowplow and included that as the initial investment. The calculation determines
whether the initial investment would produce a 10% return. You can also use NPV to tell what ini-
tial investment is required to produce the required return. That is, how much should you pay for
the snowplow? Figure 12-3 shows the calculation of the NPV of a series of cash flows with no ini-
tial investment.
The NPV calculation in cell B20 uses the following formula:

=NPV($B$3,B8:B17)+B7

18_475362-ch12.indd 320 4/14/10 10:14 PM

 Chapter 12: Discounting and Depreciation Formulas 321

Figure 12-3: The NPV function can be used to determine the initial investment required.

If the potential snowplow owner can buy the snowplow for $180,119.70, it will result in a 10% rate
of return — assuming that the cash flow projections are accurate, of course. The formula adds the
value in B7 to the end to be consistent with the formula from the previous example. Obviously,
because the initial cash flow is zero, adding B7 is superfluous.

Initial cash inflow

Figure 12-4 shows an example in which the initial cash flow (the Time 0 cash flow) is an inflow.
Like the previous example, this calculation returns the amount of an initial investment that will be
necessary to achieve the desired rate of return. In this example, however, the initial investment
entitles you to receive the first inflow immediately.

Figure 12-4: Some NPV calculations include an initial cash inflow.

18_475362-ch12.indd 321 4/14/10 10:14 PM

 322 Part III: Financial Formulas

The NPV calculation is in cell B16, which contains the following formula:

=NPV(B3,B7:B13)+B6

This example might seem unusual, but it is common in real estate situations in which rent is paid
in advance. This calculation indicates that you can pay $197,292.96 for a rental property that pays
back the future cash flows in rent. The first year’s rent, however, is due immediately. Therefore,
the first year’s rent is shown at Time 0.

Terminal values
The previous example is missing one key element: namely, the disposition of the property after
seven years. You could keep renting it forever, in which case you need to increase the number of
cash flows in the calculation. Or you could sell it, as shown in Figure 12-5.

Figure 12-5: The initial investment may still have value at the end of the cash flows.

The NPV calculation in cell D15 is

=NPV(B3,D7:D13)+D6

In this example, the investor can pay $428,214.11 for the rental property, collect rent for seven
years, sell the property for $450,000, and make 10% on his investment.

Initial and terminal values

This example uses the same cash flows as the previous example except that you know how much
the owner of the investment property wants. It represents a typical investment example in which
the aim is to determine if, and by how much, an asking price exceeds a desired rate of return, as
you can see in Figure 12-6.

18_475362-ch12.indd 322 4/14/10 10:14 PM

 Chapter 12: Discounting and Depreciation Formulas 323

Figure 12-6: The NPV function can include an initial value and a terminal value.

The following formula indicates that at a $360,000 asking price, the discounted positive cash at
the desired rate of return is $68,214.11:

=NPV(B3,D9:D15)+D8

The resulting positive NPV means that the investor can pay the asking price and make more than
his desired rate of return. In fact, he could pay $68,214.11 more than the asking price and still
meet his objective.

Future outflows
Although the typical investment decision may consist of an initial cash outflow resulting in peri-
odic inflows, that’s certainly not always the case. The flexibility of NPV is that you can have vary-
ing amounts, both positive and negative, at all the points in the cash flow schedule.
In this example, a company wants to roll out a new product. It needs to purchase equipment for
$475,000 and will need to spend another $225,000 to overhaul the equipment after five years.
Also, the new product won’t be profitable at first but will be eventually.
Figure 12-7 shows a worksheet set up to account for all of these varying cash flows. The formula
in cell E19 is

=NPV(B3,E7:E16)+E6

The positive NPV indicates that the company should invest in the equipment and start producing
the new product. If it does, and the estimates of gross margin and expenses are accurate, the
company will earn better than 10% on its investment.

18_475362-ch12.indd 323 4/14/10 10:14 PM

 324 Part III: Financial Formulas

Figure 12-7: The NPV function can accept multiple positive and negative cash flows.

Mismatched interest rate periods

In the previous examples, the discount rate conveniently matched the time periods used in the
cash flow. Often, you’ll be faced with a mismatch of rate and time periods. The most common sit-
uation occurs when the desired rate of return is an annual effective rate and cash flows are
monthly or quarterly. In this case, you need to convert the discount rate to the appropriate
period.

See Chapter 11 for a discussion on interest rate conversion.

Figure 12-8 shows a rental of $12,000 paid quarterly in advance. It also shows an initial price of
$700,000 and a sale (after three years) for $900,000. Note that because rent is paid in advance,
the purchaser gets a cash adjustment to the price. However, at the end of three years (12 quar-
ters), the same rule applies, and the rent payable for the next quarter is received by the new
owner. If you discount at 7% per annum effective, this shows an NPV of $166,099.72. The formula
in cell D22 is:

=NPV(C5,D8:D20)*(1+C5)

In some situations, determining the frequency of cash flows is simple. With rent, for instance, the
lease agreement spells out how often rent is paid. When the future cash flow is revenue from the
sale of a product, the figures are usually estimates. In those cases, determining whether to state
the cash flows monthly, quarterly, or annually is not so clear. Generally, you should use a fre-
quency that matches the accuracy of your data. That is, if you estimate sales on an annual basis,
don’t divide that number by 12 to arrive at a monthly estimate.

18_475362-ch12.indd 324 4/14/10 10:14 PM