Net Present Value

Net present value is used to calculate the present value of multiple future cash flows. NPV analysis takes all of the future cash flows and discounts them back to time 0
then compares them against the initial cost. NPV analysis can be used to analyze various business decisions. The higher the NPV the more beneficial the decision.
NPV analysis can be used to evaluate a single decision or compare several choices. Theoretically, the company should choose any decision that has a NPV greater
than 0.

This example involves the decision to purchase a new machine to replace an old one. JonesCo needs to purchase a new machine and has a choice of two machines
that will provide the same function. Machine A cost $100,000 and would provide savings of $25,000 for the next five years. Machine B cost $75,000 and would provide
savings of $20,000 for the next 5 years. The company's discount rate is 10%.

Machine A Time
0 1 2 3 4 5
Cash flows -$80,000 $15,000 $20,000 $25,000 $30,000 $35,000

Machine B Time
0 1 2 3 4 5
Cash flows -$50,000 $15,000 $15,000 $15,000 $15,000 $15,000

Machine A costs more than machine B but also provides higher savings than machine B in the future. Both machines have total savings of $25,000 over the cost of the
machine. NPV analysis can be used to find out which machine will benefit the company the most.

Machine A Machine B
NPV $3,659.68 NPV $2,758.47

Machine A has a NPV of -$5230.33, this means that the present value of the future cash flows is not enough to outweigh the costs of the machine. Machine B has a NPV
of $815.74, this means that the present value of the future cash flows is enough to outweigh the costs of the machine. NPV analysis shows that the best choice of
machinery is machine B as it provides the greatest benefit to the company.
 Net Present Value Function
NPV can be easily calculated using the net present value function in Excel. The NPV function can be found under the financial category. There is one issue
regarding the NPV function, it can only be used on future cash flows. NPV assumes all cash flows are at the end of the period and therefore discounts all cash
flows back to time 0. If there is a cash outflow at time 0 then it will erroneously discount it. If a outflow occurs at time 0, it must be added to the discounted
future cash flows. To illustrate this we will use machine B from the previous example.

Machine B

0 1 2 3 4 5 Discount Rate
Cash flows -$75,000 $20,000 $20,000 $20,000 $20,000 $20,000 10%

NPV $815.74 Formula =B8+NPV(I8,C8,D8,E8,F8,G8)

Discount Rate

Future Cash flows

Assumption that cash flows

occur at the end of the
period