WePROMOTE NPV Calculation
The Net present value (NPV) method totals all cash inflows and subtracts all cash outflows associated with a long-term investment (Accounting Tools, 2022). According to Heisinger and Hoyle (n.d.), investments are approved when the NPV exceeds or equals zero; otherwise, the investment is denied.
NPV Calculation
The net present value (NPV) approach adds the present value of all cash inflows and subtracts the current value of all cash outflows when assessing assets (Heisinger & Hoyle, n.d). There are three steps to calculating the NPV:
Step 1: Determine the quantity and timing of the cash flows necessary over the investment’s life.
Step 2: Calculate the interest rate that will be used to evaluate the investment, also known as the necessary rate of return.
Step 3: Calculate and analyze the investment’s net present value (NPV).
Alternatively, we may compute the NPV in Excel by using the formula:
NPV = Investment cost multiplied by NPV(rate, value1, [value2],…)
Therefore, in this study case:
- The purchase price of the equipment will be $80,000 and this cost is incurred prior to any cash is received by the project.
- Option 1: cash inflows $14,000 annually for 7 years. Option 2: cash inflows of $14,000 in year 1, then inflows of $16,000 from years 2–4, and then inflows of $17,000 for years 5–7.
- You both agree that after 7 years, the equipment will stop working and can be sold for its parts for about $5,000. Meaning the salvage sold is $5,000
- Required Rate of Return = 7%.
Below is the formula for each value:
PV = Net cash flows / (1+ r)^ years
NPV = Sum of Present Value of Cash Inflows − Initial investment or cash outflows.
NPV Calculation for Option 1: Cash inflows $14,000 annually for 7 years
NPV Calculation for Option 2: Cash inflows of $14,000 in year 1, then inflows of $16,000 from years 2–4, and then inflows of $17,000 for years 5–7
Conclusion and Analysis
Based on the NPV calculation of both options. We notice that the NPV result in the first alternative is poor (less than zero), hence the first option should not be executed. The second alternative, on the other hand, has an NPV larger than zero and should be executed. The distinction here is the forecasting of future cash flow. The first option demonstrates that the cash flow is steady and does not increase. This demonstrates that the business strategy contains a subjective forecast (too safe and no change). The second approach, on the other hand, thinks more carefully about market development. The cash flow improves favorably as operational time, market share, and chances to conduct business with partners rise.
I can assure my partner that option 2 will be better because the NPV is positive, meaning the business is profitable, thus it has sufficient funds to invest in the new initiative. Furthermore, the business already has a dedicated consumer base. As a result, when the project is completed, it will meet the profit projections in the first years. In addition, any business initiative will go through a development cycle.
As a result, the cash flow cannot be balanced. With its current sales crew, the business can extend its client base. Since then, the business has generated additional revenues in subsequent years. Finally, a 7% discount rate is quite secure. The IRR ratio for the project is 10.12%. As a result, the corporation will be able to increase earnings.
References:
Accounting Tools. (2022, April 23). Present value definition — AccountingTools. AccountingTools. Retrieved September 22, 2022, from https://www.accountingtools.com/articles/present-value
Heisinger, K., & Hoyle, J. B. (n.d.). Accounting for Managers. https://2012books.lardbucket.org/books/accounting-for-managers/index.html
Note:
This article is written based on University of The People Financial Management (BUS 5111) written assignment by Fristy Tania in November 2022
