Before making an investment, we always think about returns. The returns are the reason we make investments in the first place. Same way, when someone stars a new venture or a business, they think about future returns. Any investment sans returns is considered a loss. Therefore, it is required to calculate the approximate net present value before getting into action. Now how to calculate net present value?
Before we see the calculation to get net present value, we should know a little about few values and what they represent.
Free cash flow: [the gross income – (depreciation + amortization)] – changes in working capital ‑ capital expenditure (which includes dividends paid and deferred taxes and all other expenses).
This represents the venture’s working and progress. If this is low then the business venture is at loss.
Discounted cash flow: This method is used to speculate the future profits of a business venture.
The venture’s future free cash flow projections are got and they are discounted (this is done by using weighted average cost of capital). If the value of DCF is more than the investment cost, it is a good investment.
How to calculate discount?
This is very crucial in calculating NPV. Weighted average cost of capital (WACC) is a good method to calculate the discount. This calculation is more of an art. Because this is the one that will give you the future of your investment.
Present value: This is the current worth of a future cash flow given a specific rate of return or sum of money. In other words it is the present worth of a future income. Future cash flows are discounted at a calculated discount rate (the higher the discount rate, the lower the present value).
This is mainly very useful in getting to know whether your investment in profitable or not.
Now that you are aware of all the values involved in calculating NVP, obtain the values and keep them aside.
Let us keep a check list:
- Free cash flow
- Discount
- Discounted cash flow
- Present value
Net present value (NPV)
NVP is very important when making an investment. This is the difference between the present value of the cash inflows and the present values of the cash outflows. If your NVP is greater than 0, then the project is a go, if not reconsider.
Net present value determines the future of a business venture. Some people use octopuses and some use tarot cards to predict their future. Well! You can’t take chances when there is money involved. Therefore investors rely on NVP to determine whether their investment is going to be profitable or is it going to bite dust.
Although it can be calculated with the help of this formula, you can also calculate it using MS excel sheet or any other spread sheet.
Calculating NPV using MS excel
In excel sheet, you have a function NVP in Finance tab
When you select this function, MS asks you the values of the rate and consequent FCFs.
The pattern for this function is:
=NPV(rate, free cash flow1, free cash flow 2, … free cash flow n)
For example: =NPV(6,83.3,88.1,84.2)
Where 6 is the Rate
83.3 is the FCF 1
88.1 is the FCF 2
84.2 is the FCF 3
Here, n = 3
For these values you get the result as $13.94, which is clearly greater than 0.
This venture is suitable to proceed.
NVP can also be calculated using the above mentioned formula for NVP, or though some NVP value tables. But this I think using a spread sheet consumes less time and is more reliable.
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