# 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.

### Solution:

 Y0 (today) Y1 Y2 Y3 Y4 Y5 Equipment (1,000,000) Inflows 300,000 315,000 330,750 347,288 364,652 Running expenses (51,000) (52,020) (53,060) (54,122) (55,204) Existing products (60,000) (60,000) (60,000) (60,000) (60,000) Net flows (1,000,000) 189,000 202,980 217,690 233,166 249,448 Discount factor (12%) 1.000 0.8929 0.7972 0.7118 0.6355 0.5674 Present Value (1,000,000) 168,758 161,816 154,952 148,177 141,538 NPV (224,759)

### Notes:

1. Depreciation is ignored as it is not a cash flow.
2. 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.
3. 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.
4. 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.
5. Discounting is done at 12%, which is the WACC.
6. The NPV is negative, the initial cost > the present value of future cash inflows and therefore the project should not be undertaken.

## Topics

• CA Student blog