Net Present Value is the measure of potential increase/ decrease in the company’s or investors’ wealth as a result of undertaking any project. It is calculated as the sum of the present value of all project-related cash inflow, outflows, and initial investment. In order to calculate NPV we need the following information:
- All project-related cash flows (initial investment, residual value, income, expenses, etc.)
- Timeline of above cash flows
- Discount rate (also called the cost of capital i.e. the rate at which investor will be able to raise funds for the project)
A company is considering initiating a 5-year project. The project requires an initial investment of $ 5,000,000 and thereafter annual cash outflows of $ 800,000 to run operations. Expected revenue from the project is $ 2,500,000 for years 1 and 2 while $ 2,000,000 per year from year 3 onwards. The cost of capital is 10%. Assume that operational outflows and revenues will be received at the end of the respective year.