## About this lesson

The Net Present Value is a Return on Investment analysis that determines a value in monetary terms for the accumulated cost and benefits of a project over a set time period.

## Exercise files

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Net Present Value (NPV)18.9 KB Net Present Value (NPV) - Solution

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## Quick reference

### Net Present Value

The Net Present Value is a Return on Investment analysis that determines a value in monetary terms for the accumulated cost and benefits of a project over a set time period.

### When to Use Net Present Value

Like all project ROI techniques, this analysis is done as part of the preparation of the business case used to justify a project. Net Present Value (NPV) analysis is focused on value creation. This technique can be used with all types of projects from small to large and those focused both on sales benefits and productivity benefits. The only down side with this technique is that it is hard to calculate by hand, but spreadsheet software has the NPV formula and can do the calculations.

### Instructions

This ROI technique requires the use of a spreadsheet. The columns for spreading the costs are always a year in duration. Also, most companies set these columns based upon their fiscal year. Therefore, unless the project starts on the first day of the fiscal year, the project costs in the first column will represent less than a year’s worth of project effort. The NPV is always done for a predetermined number of years and the project costs and the benefits must be spread appropriately throughout those years.

The NPV technique provides a long term impact for the project because it looks beyond the point of Breakeven or Payback. The number of years to use in the analysis is determine by your business and the project type. For instance, I often use three years for IT projects because the technology changes so fast. I used seven years for new product development projects for a company that made products for use in the construction industry, and I have used 15 to 20 years for large utility projects.

This leads to one of the characteristics of NPV. It does its calculation using a Discounted Dash Flow (DCF) analysis. Discounting is a technique for reducing the value of money in the future and transforming it back to the value of money today. By doing this effects like inflation and the cost of money can be accounted for in the analysis. This discounting is done in the NPV calculation by applying a discount rate, sometimes called a hurdle rate. This number is provided by Finance and it changes based upon market and business conditions. The DCF effect is small in the first year or two (there is no DCF effect for money spent in the current year) but it soon grow large. I recommend using a DCF analysis whenever you have project that will require more than two years to payback.

So let’s talk about the NPV formula. This formula will require three types of information. First is the number of years in the analysis. Second is the annual or period total from the spreadsheet for each of those years (do not use the cumulative). Finally, it will use the discount rate from Finance. Each year annual cash flow total is discounted and then all of the discounted cash flows are summed up to determine the total Net Present Value.

This analysis can be done using the ROI spreadsheet that we illustrated in the module on ROI. However, be careful when using the Excel NPV formula. Excel starts discounting the first annual cash flow value that is in the formula. If you are preparing an NPV analysis for a project that will start next year, that is appropriate. However, if you are preparing an NPV analysis for a project that will be starting in the current year, the annual cash flow for the current year should be excluded from the NPV calculation. Just start the NPV formula with the value from “Next” year and then add in the value for the current year to the NPV calculation. See the example below using the Excel formula.

Theoretically, any NPV that is greater than zero makes money for the business. However, my rule of thumb is that I like to see an NPV that is at least 50% of the value of the project so that if the project estimates or the benefit estimates are off – either amount or timing, the project will still have a positive impact.

### Hints and Tips

- This technique provides a long range view of the project. The best project from an NPV perspective may not be the best one from a Payback Period or Breakeven Point perspective. Find out from your stakeholders which is more important to them, near term profit or long term profit.
- If the discounting will go on for a long period (more than 8 years) even a minor change in the discount rate can have a very large impact on NPV. Make sure that you are using the correct rate. Finance often will have different rates for different types of projects.
- Do not use the cumulative totals, use the annual totals. This is the most common mistake made when using this technique.
- Some business will want to spread the investment portion of the project costs based upon the annual depreciation values instead of the actual cash flow. This will inflate the NPV some, but it will provide a value that is more likely to align with the impact of the project on the Net Income. Follow whichever method your company directs you to use.

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