Rav Panesar, founder of online diary app and social enterprise Rymindr, is always looking to invest in new technology that will improve the service offered to subscribers.
But Panesar is also keen to ensure he gets the best return on any investment he makes. “We recently launched a new service enabling school staff to track appointments and events," he says. "But before making that investment, we needed to feel confident that we’d get an appropriate rate of return so we'd hit our revenue and social targets.”
As part of the evaluation process, Panesar and his internal accounts team use the net present value formula (NPV) to forecast the likely return of new investments.
What is net present value (NPV)?
Net present value or NPV is an economic formula that illustrates the relative value of different investments. “If you have capital to invest and want to understand whether you’ll be better off investing in new equipment or upgrading your premises, then NPV could be used to compare the future value of those two investments,” says Frances Fawcett, an independent business consultant and member of the Institute of Leadership and Management.
Why is NPV important?
NPV can help drive decision-making in a business, says Fawcett. “If I offer to give you £500 now, or £550 in a year’s time, it’s hard to know on the face of things which is the better offer,” she says. “NPV encourages you to consider whether that £550 in a year’s time will be of greater value to the business.”
Net present value advantages and disadvantages
Advantages
When Panesar evaluates new potential features for Rymindr, he uses NPV to help compare the likely future value of the different options. The one with the highest NPV is generally the best choice.
NPV can also be useful when valuing a company as an outside investor, says Fawcett. When investors don't have all the data about a company’s financials, NPV provides a useful metric based on industry averages.
Disadvantages
The key disadvantage of NPV is that it’s a purely economic formula, which doesn’t account for real-world factors that influence the future value of investments. “You can use NPV to look at the future value of investing in new equipment, but it doesn’t consider the possibility that new equipment might reduce the cost of manufacturing items or increase production,” says Fawcett.
“NPV is only one of the tools that should be used when evaluating potential value and return on investment," she says. “Remember that NPV is based on the future, which means it’s based on assumptions. Look at other numbers from your business and consider expert advice to support the figures generated by NPV.”
How to calculate NPV
To calculate NPV, you’ll need to know the following information:
- The initial cost of the suggested investment. For example, if you’re buying a new delivery truck, what is the upfront cost?
- How long it will take for the investment to pay for itself. If you usually keep vehicles for five years, use this time period when calculating the NPV of investing in a new truck.
- The relevant discount rate to apply. In general £1 today will be worth more than £1 in future (due to inflation and interest rates); exactly how much more varies by industry. If the rate of return in delivery businesses is typically 5%, then the discount you’ll apply to NPV is 0.05.
With this information, you can use the NPV formula below to add up the discounted cash flows for your proposed investment and deduct the upfront investment.
Net present value formula
The formula to calculate NPV is:
NPV = Rt / (1+i)t - C
In this formula:
- R = net cash flow at time.
- t = time of the cash flow.
- i = the discount rate.
- C = the initial investment.
In simple terms, NPV is the value (in today's currency) of future net cash flow (R) by time period (t). To calculate NPV, start with the net cash flow (earnings) for a specific time period expressed as an amount in pounds sterling.
Divide that by the product of 1 plus the discount rate (i) expressed as a decimal.
The discount rate can be the rate of return you expect to receive from this investment, the rate of return you could receive from an alternative investment, or the cost of the capital required to fund a project.
Cash flow
Cash flow represents how much money the investment is likely to make in the specified time period. You might estimate that a new piece of machinery could produce 20% more products per year, and based on your known profit margin, this translates into £500,000 in additional revenue.
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Time period
This is the likely payback period of the investment being considered, typically expressed in years.
Discount rate
Knowing how to calculate NPV with a discount rate is useful if you don’t have specific data relating to your own business. It refers to the average expected rate of return for a particular industry, based on results from thousands of other businesses.
Initial Investment
This relates to the upfront investment or purchase price of the proposed investment.
Example of an NPV calculation
A delivery company wants to invest in 10 new vehicles, at an upfront cost of £40,000 per vehicle. Typically, the company keeps trucks for five years before they become unreliable, so the NPV calculation is to understand the likely value of investing £400,000 over five years. The new vehicles will allow the company to generate additional revenue of £200,000 each year.
The industry has an average discount rate of 3.5%.
In this case the NPV calculation would be:
NPV: (£200,000 x 5) / (1+0.035)5 – £400,000 = £441,973
This gives a net present value of £441,973. This can be compared against the cost of leaving the proposed £400,000 investment in the bank for the same period, or the NPV of an alternate investment to identify whether the new vehicles represent a good investment.
How to use NPV
At Rymindr, the finance team will calculate NPV as part of its review process for all new investments over a set amount. “We have set a certain threshold of return that we expect potential investments to show in NPV. If the project is not going to hit that threshold, then we wouldn’t proceed,” says Panesar.
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