As mentioned in the previous posts there are a number of factors (metrics), which need to be accounted for when putting
a business case together. One example could be where a corporation has employed you to decide whether to introduce a
new product line. Metrics to be included in this calculation include:
 Startup expenditures,
 Operational expenditures,
 Incoming cash receipts (sales)
 Disbursements (Cash paid for materials, supplies, direct labor, maintenance, repairs, and direct overhead)
 Over the life cycle of the product.
The NPV (Net
Present Value) is the forecast financial outcome of a new product initiative. It
will enable you to give a fairly accurate forecast on the earning potential. Calculating
it will firstly tell the business if the product initiative will return a
benefit to the business relative to the cost of financing the investment, and
secondly the NPV provides a standard yardstick by which to measure one
initiative against another. However, there are many variables in the forecast
such as the price of employing people to make the product or inflation rates.
The concept is based
on the way that the value of money changes over time.
For example, lets say
that I have been asked to choose between being given either:
Option 1 – $1000 today
Option 2 – $1100 in 2
years
At first glance it looks like Option 2 is a
better deal because I will get more cash in the hand. But I also need to
consider what the value of Options 1′s $1000 will be in 2 years. This will depend on the interest rate
applied to it.
Assuming an interest rate of 5% pa the
$1000 will be worth $1050 ($1000*1.05=$1050) after 1 year and $1102.50 after 2
years ($1050*1.05=$1102.50).
So in this case the FUTURE VALUE of Option
1 is $1102.50 versus Option 2′s $1100
if we wait for 2 years. So, I am better to select Option 1 $1000.
The NPV does this
calculation in reverse. Instead of calculating the FUTURE VALUE of today’s
money it converts all current and future revenue and costs into PRESENT VALUE. Again using the example above, the PRESENT VALUE of Option 1 is $1000,
and PRESENT VALUE of Option 2 is $997.73. In addition to the monetary values
being entered we also need the rate (called the Discount Rate) to be used and
the number of years (or periods) to be calculated.
Step 1: Determine
the expected cash flows associated with the project or investment.
Assume that the widget
machine would cost $100 (although these numbers will work equally well
expressed in other currencies). You expect that implementing the widget machine
will bring in an additional $50 the first year, $40 the second year, and $30
the third year (the law of diminishing marginal returns). After 3 years, you
expect that the juicer will need to be discarded. So, your expected cash flows
are: $100 right now, +$50 in year 1, +$40 in year 2, and +$30 in year 3. It is
a good idea to diagram these cash flows on a piece of paper.
Step 2: Determine
the appropriate discount rate.
This
step is crucial to a good analysis, and also requires the most discretion. The
discount rate is a number used to convert the values of the expected future
cash flows into their present values. This is necessary because of what is
known as the "time value of money."
The value of money
depends on when it is expected to be paid.
 For example, you should generally prefer
to receive $100 right now than to receive $100 3 years from now. This is
because you could have been investing that $100 over those 3 years, and at
the end of that period, you would likely have more than your original
$100. Therefore, $100 expected in 3 years is actually worth less than $100
right now. All future cash flows must be discounted back to their
equivalent present values.
 Determining the appropriate discount rate
requires some consideration; in corporate finance, a firm's
weightedaverage cost of capital is often used. In the lemonade stand
example, you might decide that if you didn't purchase the widget machine,
you would probably invest the money in the stock market, where you feel
confident you could earn 4% annually on your money. So, 4% is the
appropriate discount rate.
Step 3: Discount
all the cash flows and calculate NPV.
This is done using a
simple formula: P / (1 + i)^t, where P is the amount of the cash flow, i is the
discount rate, and t represents time. Cash flows that occur immediately do not
need to be discounted, as they are already expressed as present value. Using a
4% discount rate, you can get the output of the NPV.
Step 4: Decide if
the project is profitable enough.
NPV is an indicator of
how much value an investment or project adds to the firm. With a particular
project, if NPV given is a positive value, the project is in the
status of positive cash inflow in the time of t (usually your
chosen year 0).
If NPV is a negative
value, the project is in the status of discounted cash outflow in the time of t.
Appropriately risked projects with a positive NPV could be accepted.
In financial theory,
if there is a choice between two mutually exclusive alternatives, the one
yielding the higher NPV should be selected.
If...

It means...

Then...

NPV > 0

the investment would
add value to the firm

the project may be
accepted

NPV < 0

the investment would
subtract value from the firm

the project should
be rejected

NPV = 0

the investment would
neither gain nor lose value for the firm

We should be
indifferent in the decision whether to accept or reject the project. This
project adds no monetary value. Decision should be based on other criteria,
e.g., strategic positioning or other factors not explicitly included in the
calculation.

NPV Excel Spreadsheet Download Link Here
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