How to calculate NPV

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By Joanne Lloyd-Jones, TPS Afin Subject Controller

27 July 2016

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)Y1Y2Y3Y4
Y5
Equipment(1,000,000)     
Inflows 300,000315,000330,750347,288364,652
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)189,000202,980217,690233,166249,448
Discount factor (12%)1.0000.89290.79720.71180.63550.5674
Present Value(1,000,000)168,758161,816154,952148,177141,538
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

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