Net Present Value (NPV)
The formula for NPV is:
Let's assume Company XYZ wants to buy Company ABC. It takes a careful look at Company ABC's projections for the next 10 years. It discounts those projected cash inflows back to the present using its weighted average cost of capital (WACC) and then subtracts the cost of purchasing Company ABC.
Cost to purchase Company ABC today: $1,000,000
Present value (PV) of cash flows from acquiring Company ABC:
Year 1: $200,000
Year 2: $150,000
Year 3: $100,000
Year 4: $75,000
Year 5: $70,000
Year 6: $55,000
Year 7: $50,000
Year 8: $45,000
Year 9: $30,000
Year 10: $10,000
Now that we know the total cash flow for the next 10 years (the total cash inflows from the investment), along with total cost of the investment in Company ABC, we can use the formula to calculate NPV:
Net Present Value (NPV) = $785,000 - $1,000,000 = -$215,000
NPV is used to analyze an investment decision and give company management a clear way to tell if the investment will add value to the company. Typically, if an investment has a positive net present value, it will add value to the company and benefit company shareholders.
Net present value calculations can be used for either acquisitions (as shown in the example above) or future capital projects. For example, if a company decides to open a new product line, they can use NPV to find out if the projected future cash inflows cover the future costs of starting and running the project. If the project has a positive NPV, it adds value to the company and therefore should be considered.