# 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:

- 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.