Why do you need a net present value calculator? The answer is for decision making. Let’s take the example of a real estate investor. She may have a choice of 3 different investments. With only enough money for one of them, which one does she choose?
The obvious answer is to choose the one with the most profit. The npv calculator is a method for deciding which of the alternatives is projected to make the most money. So, the simple answer is to choose the investment that has the highest net present value. You would simply put in the expected net return minus expenses for each year of the life of the investment with the discount rate for each of the investment alternatives. The biggest net number wins!
It also gives you your ROI or Return on Investment for a given project or investment. It is much more accurate than the payback method because it takes into account the buying power of money today versus the buying power in the future.
How Does NPV Work?
How does it do it? It takes all of the cash flows over the life of the investment and summarizes them into one number that represents that project’s value to the investor today. Analyzing the term net present value, it means the net or all the plus and minus cash flows brought back to the present and totaled to get the net value for the present time. This is done by using a process called discounted cash flow.
How do you discount a cash flow that is projected to occur in the future? You would use a discount rate or interest rate. The logic of this can be seen with the example of a savings account. If a $100 in a savings account earns 3% per year, then in one year your account would be $103 and in 2 years about $106. So, this tells you that if you were offered $100 in one year or $100 right now, your best choice would be $100 today because the $100 one year from now would be worth less that it be to day. This concept is called the time value of money.
Now you might choose to use this 3% discount rate, because it is the risk-free rate to you. However, to compensate for the increased risk of your prospective investment, you might want to add a few percentage points to include the risk-free rate as well as a risk premium. Now a corporation that borrows money to invest in projects internally might want to use a base rate of the average cost of capital.
There are several types of situations where you might be making an analysis.
1. A single alternative. You would accept the investment if you have a positive NPV. (A positive NPV means that the rate of return is greater than the discount rate.)
2. Multiple profitable investments. You would choose the investment with the highest positive NPV.
3. Multiple investments to satisfy a requirement. If there are multiple alternatives that would meet a regulation or possibly a safety issue, then you want the investment with the lowest lifetime cost. The choice would be the alternative that has a negative NPV closest to zero.
The answer to this question is maybe. The IRR Calculator may give a clearer picture of an investment’s financial benefits. This is especially true when comparing projects with different lives. Although adjustments can be made to the NPV calculation to account for the unequal lives, the analysis is much more straight forward when using an IRR calculation. When you see the IRR results as a percentage return the value of an investment may be more intuitively obvious. However, the IRR may show unexpected results. Therefore, it is a good practice to evaluate an investment using both techniques.
You will see two series of cash flows. Each series of cash flows support the net present value results at the bottom. To obtain a NPV for your cash flows, you need to supply the actual cash flows from each project. You will also need to supply the discount rate. Be sure to clear out the numbers to zero for the years not needed. The year column can be changed by just changing the first year. Play close attention to the numbers that you put into your analysis. You don't want the expression "Garbage in, garbage out." to apply to an analysis that you are using to make an important business decision.
Listed below are a few possible applications that you might use NPV analysis:
1. Comparing alternatives with unequal lives.
2. Estimating cash flows years into the future.
3. Inflation variability of over future years.
4. Black swan events that disrupt cash flows.
Once you have used the NPV calculator to calculate net present value for your projects, you can make a rational decision about which project is most economical for your situation.