Back to basics: How to calculate Net Present Value and determine investments
Net present value (NPV) is a method used by businesses to determine whether investments (projects) are worthwhile or not. We continue our look at how to calculate value through a worked example.
Worked example (TPS level):
ABC Ltd are currently considering an investment in a new project:
- The project requires the purchase of £1m of equipment which will generate revenue for the next five years.
- The equipment will be paid for upfront and will be depreciated on straight line basis over five years.
- The equipment will be scrapped at the end of the five years.
It is estimated that the cash inflows generated will be £300,000 in the first year of the project, rising at 5% per annum. The running costs of the equipment are estimated at £50,000 in current terms. These are expected to rise at 2% per annum and will be paid at the end of each year.
As a result of this project, it is expected that existing product sales will fall. It is estimated that this will reduce cash inflows from existing products by £60,000 per annum over the next five years.
ABC Ltd have a weighted average cost of capital (WACC) of 12% and have asked you to advise whether the project should be undertaken.
|Discount factor (12%)||1.000||0.8929||0.7972||0.7118||0.6355||0.5674|
- Depreciation is ignored as it is not a cash flow.
- The generated cash inflows are given as £300,000 in Year 1 (Y1); these are then inflated at 5% per annum for years 2 – 5.
- The running expenses are given in current terms – this is today’s prices (Y0), so we inflated these at 2% per annum for Y1 – Y5.
- The reduction in cash flows relating to other products must also be included (incremental costs) – these are given as a fixed amount of £60,000 per annum and therefore do not need to be inflated.
- Discounting is done at 12%, which is the WACC.
- The NPV is negative, the initial cost > the present value of future cash inflows and therefore the project should not be undertaken.