NPV Project Management
**What is NPV?**
a) If the value of NPV is greater than 0, then the project is a go! In other words, it's profitable and worth the risk.
b) If the value of NPV is less than 0, then the project isn't worth the risk and is a no-go.
So NPV takes risk and reward into consideration, which is why we use it in the world of corporate finance and capital budgeting.
**Example**
In order for us to calculate NPV, let's use the following example.
Suppose we'd like to make 10% profit on a 3 year project that will initially cost us $10,000.
a) In the first year, we expect to make $3000 b) In the second year, we expect to make $4300 c) In the third year, we expect to make $5800
**Calculation step 1**
Right now, the project is going to cost us $10,000. So we won't be making any money until at least a year from now. What we need to do is calculate how much each of those future profit amounts will be worth right here, today.
This means we need to calculate the present value of each of those 3 cash flows we'll be getting over the next three years. In other words:
a) How much is that $3000 one year from now worth today? b) How much is that $4300 two years from now worth today? c) How much is that 5800 worth three years from now worth today?
The answers to each of these three questions is the present value for that particular cash inflow.
**Calculation step 2**
In example, I'd like to make a 10% profit. This is important because it's the bare minimum we'll need to make in order to say yes to this project. In corporate finance, we call this rate our required rate of return (ROR).
To get our present values, we use this ROR!
In other words, we ask ourselves:
a) Earning 10%, $3000 one year from today would be worth how much right now?
b) Earning 10%, $4300 two years from today would be worth how much right now?
c) Earning 10%, $5800 three years from today would be worth how much right now?
**Calculation step 3**
a) If the value of NPV is greater than 0, then the project is a go! In other words, it's profitable and worth the risk.
b) If the value of NPV is less than 0, then the project isn't worth the risk and is a no-go.
So NPV takes risk and reward into consideration, which is why we use it in the world of corporate finance and capital budgeting.
**Example**
In order for us to calculate NPV, let's use the following example.
Suppose we'd like to make 10% profit on a 3 year project that will initially cost us $10,000.
a) In the first year, we expect to make $3000 b) In the second year, we expect to make $4300 c) In the third year, we expect to make $5800
**Calculation step 1**
Right now, the project is going to cost us $10,000. So we won't be making any money until at least a year from now. What we need to do is calculate how much each of those future profit amounts will be worth right here, today.
This means we need to calculate the present value of each of those 3 cash flows we'll be getting over the next three years. In other words:
a) How much is that $3000 one year from now worth today? b) How much is that $4300 two years from now worth today? c) How much is that 5800 worth three years from now worth today?
The answers to each of these three questions is the present value for that particular cash inflow.
**Calculation step 2**
In example, I'd like to make a 10% profit. This is important because it's the bare minimum we'll need to make in order to say yes to this project. In corporate finance, we call this rate our required rate of return (ROR).
To get our present values, we use this ROR!
In other words, we ask ourselves:
a) Earning 10%, $3000 one year from today would be worth how much right now?
b) Earning 10%, $4300 two years from today would be worth how much right now?
c) Earning 10%, $5800 three years from today would be worth how much right now?
**Calculation step 3**