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Net Present Value

>> March 8, 2010

Net present value method is that method of capital budgeting  which is considered better than pay back period method and rate of return method for evaluation the investment proposals or assets of different companies. In NPV method, we calculate net present value of cash flows after deducting present value of cash outflows from present value of cash inflows. This NPV is calcuated for each investment project. Only that investment project is accepted whose net present value will be high. Now, you can understand what is this method. In this method, I have used the term present value. Without knowing present value, you can not calculate net present value.

Simple Definition of Present Value and Value of Money

Present value means today value of one dollar. It is also value of money. Given money is one dollar. It may possible that value of one dollar may increase after one year because

#1.  Receiving of Interest on one dollar for one year.

#2.  Value of money may increase fluctuations in foreign exchange.

#3.  Value of money may increase due to deflation in world market.

#4.  Even in inflation, prices will increase and we need 2 dollar instead one dollar for buying same quantity. It means trend of value of money will always be upward.

So, today received one dollar is very important than what we receive tomorrow and Due to this reason, we fix a discount rate. It is the rate, which we like. At this rate, we want to invest our all money. On this rate, we can calculate present value of one dollar payable or receivable annually from present value table.

Simple Steps for calculating NPV

1st Step

To determine Discount Rate

This rate may be 8%, 9% or above according to financial market condition.

2nd Step

To calculate Present Value of Cash outflow or Initial Investment

It is calculated just by multiplying cash outflow with the present value of discount rate. If we invest today, then need not multiply because today investments means PV of Cash outflow.

3rd Step

To calculate the Present Value of Cash inflows or profit before depreciation and after tax

We can calculate PV of cash inflows by multiply present value of discount rate.

PV of Cash inflows = Cash inflows X Factor Value of Discount Rate

(For example, if we have to receive today 0.90 $ instead of $ 1. Then it will automatically $ 1 after one year, so if we multiply this 0.90 $ with Cash inflow, then cash inflow will become the amount which we receive today not in future. )

{Note: Present income is more important than future income}

4th Step

To Calculate Net Present Value

NPV = Present Value of Cash inflow – Present Value of Cash outflow

Calculation of NPV in Case Inflation

In case of inflation, we have to find real rate from nominal or discount rate and inflation rate.

In this section, I give you the introduction about how to get net present value of cash flows if inflation rate is given. It is very easy by using excel formula. Suppose, you have to buy machine of 10 million dollars. This is cash outflow and then after one year you have to receive cash inflows. For calculating net present value, you need real rate. If  Nominal rate or discount rate is  11% and  inflation is 5%, then you have to calculate real rate in excel sheet by using following formula.

Real rate = (1 + inflation rate ) / ( 1 + inflation rate) – 1

Now we calculate present value of cash inflow and present value of cash outflow on the basis of real rate.

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Sean Geddert September 21, 2014 at 7:56 PM  

Real rate = (Nominal rate/Inflation rate) -1*

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