Net Present Value

Net Present Value Net present value is used to calculate the present value of multiple future cash flows. NPV analysis takes all of the future cash flows and discounts them back to time 0 then compares them against the initial cost. NPV analysis can be used to analyze various business decisions. The higher the NPV the more beneficial the decision. NPV analysis can be used to evaluate a single decision or compare several choices. Theoretically, the company should choose any decision that has a NPV greater than 0. This example involves the decision to purchase a new machine to replace an old one. JonesCo needs to purchase a new machine and has a choice of two machines that will provide the same function. Machine A cost $100,000 and would provide savings of $25,000 for the next five years. Machine B cost $75,000 and would provide savings of $20,000 for the next 5 years. The company's discount rate is 10%. Machine A Cash flows 0 -$100,000 1 $25,000 Time 2 3 $25,000 $25,000 4 $25,000 5 $25,000 Machine B Cash flows 0 -$75,000 1 $20,000 Time 2 3 $20,000 $20,000 4 $20,000 5 $20,000 Machine A costs more than machine B but also provides higher savings than machine B in the future. Both machines have total savings of $25,000 over the cost of the machine. NPV analysis can be used to find out which machine will benefit the company the most. Machine A NPV -$5,230.33 Machine B NPV $815.74 Machine A has a NPV of -$5230.33, this means that the present value of the future cash flows is not enough to outweigh the costs of the machine. Machine B has a NPV of $815.74, this means that the present value of the future cash flows is enough to outweigh the costs of the machine. NPV analysis shows that the best choice of machinery is machine B as it provides the greatest benefit to the company. Net Present Value Function NPV can be easily calculated using the net present value function in Excel. The NPV function can be found under the financial category. There is one issue regarding the NPV function, it can only be used on future cash flows. NPV assumes all cash flows are at the end of the period and therefore discounts all cash flows back to time 0. If there is a cash outflow at time 0 then it will erroneously discount it. If a outflow occurs at time 0, it must be added to the discounted future cash flows. To illustrate this we will use machine B from the previous example. Machine B 0 -$75,000 $815.74 1 $20,000 2 $20,000 Formula 3 $20,000 4 $20,000 5 $20,000 Discount Rate 10% Cash flows NPV =B8+NPV(I8,C8,D8,E8,F8,G8) Discount Rate Future Cash flows Assumption that cash flows occur at the end of the period