How do you decide when to make an investment in your business? If you owned a restaurant, how would you know when you can afford to expand your dining room or open a new location? Or, if you owned a construction company, how would you whether you should purchase top-of-the-line equipment that could help your company win large paving contracts?
If you calculate the net present value (NPV) of the investment you’re planning, it can help you determine whether your investment is worth your hard-earned money.
So what is net present value, and how do you calculate it?
What Is Net Present Value (NPV)?
NPV is a way of analyzing cash flow that considers the time value of money and the riskiness of an investment. NPV discounts future cash flows at your capital cost to the present after adjusting for risk.
Essentially, it’s a way to calculate your return on investment by looking at the money you could make and comparing it using today’s dollars.
The value of money changes over time because of a discount rate — which could be interest, inflation or the expected rate of return on an investment. Think of it this way: If someone offered you $250 today or $50 every year for the next five years, which would you take? If you assumed a 10% discount rate, receiving $50 per year would only be worth about $190 in today’s dollars after five years. So you’d take the $250 now.
What Do Positive and Negative Present Values Mean?
NPV yields a more realistic analysis of an investment’s feasibility, NASDAQ says, because it uses the basic idea that a dollar tomorrow is worth less than a dollar today to determine the value of an investment. When you calculate NPV — which you can do with an NPV calculator, like this one from Omni Calculator — you might find that it exceeds or is less than the amount of the investment.
If the discounted future cash inflows of a project or expense exceed the cost of the investment, you’ll see a positive NPV — meaning the investment is probably worthwhile. If the discounted future cash flows are less than the initial cost of the investment, the NPV is negative — and the investment isn’t financially viable at this discount rate. That doesn’t necessarily mean that the investment will lose money, but you’ll need to think long and hard about whether it’s worthwhile.
How Do You Use Net Present Value?
Let’s consider our hypotheticals again.
Suppose you own a construction company and you want to buy a piece of high-grade machinery so you can take on bigger projects. You’re thinking about purchasing a motor grader for $125,000, and you project that this piece of equipment will help you win projects that will generate $50,000 in contracts each year for the next five years. Assuming a 10% discount rate, your investment will have an NPV of $64,539. Because the NPV is positive, it makes sense to purchase a motor grader.
Now, suppose you’re a restaurant owner, and you’re considering opening a new location that will require an investment of $250,000. You project revenues will be $25,000 in the first year, $50,000 in the second year and $80,000 in years three through five. Because of the uncertainty in the projections, you compensate for the risk by using a higher discount rate of 15%. Here, your investment would have a negative NPV — it would lose $52,338. Because NPV is negative, you might want to hold off on opening that new location.
Being a successful and savvy business owner means taking smart risks. You’d probably love to keep growing your business, but you need to ensure that every investment you make is a sound one. Knowing how to calculate and use NPV can help keep you out of the red.