1.12 Net Present Value (NPV)
Definition of NPV: The NPV provides the analyst with the present value, after deducting costs, of the project’s pro-forma cash flows (or accounting income) in one consolidated, TVM-consistent, number. It tells the analyst the extent to which the project is expected to enrich the firm – or not – on a “present value” basis.
An example follows. See if you can complete the spreadsheet, given the assumptions below.
Example 1: “Uneven and Growing Cash Inflows”
Given:
1. Initial Outlay: $2,500
2. Cash Inflows (CF): As below
3. No salvage value (“Salvage Value” is the residual value of equipment, i.e., after it has been used up. For example, machinery may be sold for its scrap value at its life’s end.)
4. k = 8% (i.e., the discount rate or “cost of capital”)
| Year | Free Cash Flow |
| 1 | $250 |
| 2 | 500 |
| 3 | 1,000 |
| 4 | 1,500 |
| 5 | 2,000 |
Solution: Fill in the appropriate data below.
| Year | Free Cash Flow | PV Factor | PV of the Cash Flow |
| 0 | |||
| 1 | |||
| 2 | |||
| 3 | |||
| 4 | |||
| 5 | |||
| NPV = |