The calculation of the net present value (NPV) is a budgeting technique that equates the discounted cash flows against the initial investment. The mathematical formula is:
$$NPV = \sum_{t=1}^{n}\frac{FV_{t}}{(1 + k)^{t}} – I$$
Where:
FV = Future cost of the cash inflows,
I = Initial Investment
k = Discount rate equal to the owner’s cost of capital
I will demonstrate with an example. Let’s say a project represents a series of cash flows that looks like this:
| Year | Cash Inflows | Present Value (at 10% discount rate) |
|---|---|---|
| 1 | $1,000 | $909 |
| 2 | $2,000 | $1,653 |
| 3 | $2,000 | $1,503 |
| 4 | $5,000 | $3,415 |
| 5 | $2,000 | $1,242 |
| Present Value of cash inflows (Total) | $8,722 | |
| Less investment | $10,000 | |
| Net Present Value | ($1,278) | |
In this hypothetical example, each of the cash flows discounted to the present will not recover the initial investment, and this investment should not be made.
- If the Net Present Value is greater than zero, accept the project.
- If the Net Present Value is less than zero, decline the project.
