Net present value is the present value of net cash inflows generated by a project including salvage value, if any, less the initial investment on the project. It is one of the most reliable measures used in capital budgeting because it accounts for time value of money by using discounted cash inflows.
Before calculating NPV, a target rate of return is set which is used to discount the net cash inflows from a project. Net cash inflow equals total cash inflow during a period less the expenses directly incurred on generating the cash inflow.
Calculation Methods and Formulas
The first step involved in the calculation of NPV is the determination of the present value of net cash inflows from a project or asset. The net cash flows may be even (i.e. equal cash inflows in different periods) or uneven (i.e. different cash flows in different periods). When they are even, present value can be easily calculated by using the present value formula of annuity. However, if they are uneven, we need to calculate the present value of each individual net cash inflow separately.
In the second step we subtract the initial investment on the project from the total present value of inflows to arrive at net present value.
Thus we have the following two formulas for the calculation of NPV:
When cash inflows are even:
NPV = R ×1 − (1 + i)-n− Initial Investment
In the above formula,
R is the net cash inflow expected to be received each period; i is the required rate of return per period;
n are the number of periods during which the project is expected to operate and generate cash inflows.
When cash inflows are uneven:
NPV =R1+R2+R3+ ...− Initial Investment
(1 + i)1(1 + i)2(1 + i)3
i is the target rate of return per period;
R1 is the net cash inflow during the first period;
R2 is the net cash inflow during the second period;
R3 is the net cash inflow during the third period, and so on ...