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The ability to perform net present

value calculations is a great skill to have.


The applications are limitless and net present
value is very flexible. Research indicates that it
is one of the best financial decision tools available.
Fortunately, once you see how it works it is a very
simple tool to use.



Use your Arrow Keys to navigate the slides.
Two Keys to Success

There are two keys to success when doing net present value:


cash flows

and interest rate



When doing NPV problems, the two keys to success are
guesses (estimates). They are important guesses because
they affect the outcome of the NPV analysis and your
decision.

Cash Flows

Usually, a business project or business investment will have
cash flows. That is, sometimes an entity doing a project will
be spending money and sometimes the business entity will be
receiving money. Money going out of the entity is called a
negative cash flow and money received by the entity is
called a positive cash flow.

The focus of a NPV analysis is cash flows. A primary job of
a person doing a NPV analysis is determining the amount and
the timing of cash flows. As mentioned before, cash flows
are usually an estimate.
Interest Rate

In order to do a NPV analysis, you need to have an interest
rate. Interest rates vary depending on what you want to do.
Credit cards offer various interest rates, and mortgages,
savings accounts, etc will offer even different interest
rates. In addition, interest rates change frequently.

As with cash flows, the interest rate used in a NPV analysis
is a guess. Although just an estimate, the interest rate
used in the analysis will have a huge impact on the outcome
of the analysis and therefore the business decision.
So what interest rate should be used?
What Interest Rate Should be Used?

Since the interest rate used in a NPV analysis is a guess,
there are many different ways to choose an interest rate.
The interest rate should be chosen carefully because the
interest rate will affect the decision in a very big way. In
fact, unprofitable projects can be made to look profitable,
simply by the the interest rate used in the analysis. Of
course, the opposite can occur also.

Here is one common way to choose an interest rate:
Usually a business will have a rate of return on investments
and projects that the organization strives to achieve. That
rate might be 15%, 20%, 25%, etc. It depends on the
business and the policy of the management. Start with the
desired rate of return and add a percentage point or two if
the project is not too risky. If the project is very risky,
add several percentage points to the desired rate of return.
The Timing of Cash Flows

As said before, the amounts and timing of cash flows need
to be estimated. Since NPV is a method of analyzing future
alternatives, and the future is usually quite uncertain, there
is a limit as to how precise the timing of cash flows can be
determined. For example, a person could try to forecast
future cash flows to the day and hour, but that would be
too impractical and the person would probably be wrong
anyway.

Most people believe the trade-off between accuracy and
practicality is a year. That is, when people do NPV, they
only attempt to estimate cash flows to the nearest year.
For example, any cash flows taking place in a given year are
assumed to take place on the last day of that given year. A
very rough estimate, but it works in most cases and it
simplifies the NPV analysis.
Recognizing Some Cash Flow Patterns

There are only two types of cash flow patterns used in NPV
analysis.

Lump Sum

and Annuity

A lump sum is just what the name implies. A lump sum of
money, received or paid, on a certain date. For example: a
person receives (or pays out) $1,000,000 at the end of year
2018.

An annuity is a series of equal payments over equal periods
of time. For example: a person receives (or pays out)
$10,000 at the end of each year for the next 20 years.



Solving NPV Problems

The key to solving NPV problems is the time line. A time
line looks as follows:
1 2 3 4 5 6 7
The numbers indicate the years (sometimes called periods).
Always draw a time line when doing complex NPV problems.
Entering the Cash Flows
You place the estimated cash flows onto the time line in
order to gain a clear understanding of the cash flow
patterns. The following is an example:
1 2 3 4 5 6 7
The cash flow shown represents a positive cash flow (cash
received) of $1,000 at the end of year 4. It also represents
a lump sum as opposed to an annuity.

$1,000
Entering the Cash Flows

Here is another example:
1 2 3 4 5 6 7
The cash flow shown represents a negative cash flow (cash
paid out) of $1,000 at the end of each year, years 1 5.
This is a good example of an annuity.

- $1,000 - $1,000 - $1,000 - $1,000 - $1,000
Everything Needed to Solve the NPV Problem
The last thing to enter is the interest rate being used in
the analysis. This problem is going to use 15%

15%
1 2 3 4 5 6 7
I usually place the interest rate used in a prominent place
above the time line.

- $1,000 - $1,000 - $1,000 - $1,000 - $1,000
Everything Needed to Solve the NPV Problem (really)
Last slide I said that we had everything we needed to solve
the problem. I forgot one important thing: either a
calculator that can do cash flows or present value tables.

15%
1 2 3 4 5 6 7
Since every calculator is different to operate, I will solve all
of the problems using the present value tables. You can find
present value tables in the back of any accounting or finance
book.

- $1,000 - $1,000 - $1,000 - $1,000 - $1,000
Problem #1: Solving an Annuity Problem
By looking at the time line below, it is easy to see that the
cash flows represent an annuity (equal payments & equal
periods of time). You need to look at the Present Value of
an Annuity Table to get the factor.
15%
1 2 3 4 5 6 7
Looking at the Present Value of an Annuity Table you see
Interest Rates along the top of the table and Periods down
the left side of the table. In problem #1, the interest rate
is 15% and the number of periods is 5. The payments
happen each and every year, starting at the end of year 1
and terminating at the end of year 5.

The appropriate factor from the table should be 3.35216
or something close to it.

- $1,000 - $1,000 - $1,000 - $1,000 - $1,000
Problem #1: Solving an Annuity Problem
On the last slide we found the factor to be 3.35216
15%
1 2 3 4 5 6 7
All you do to find the answer is multiply the factor times
one of the payments.

Present Value = 3.25216 x -$1,000

Present Value = -$3,252.20 (negative number)

That is all you do to find the PV of an annuity.

- $1,000 - $1,000 - $1,000 - $1,000 - $1,000
PV = -$3,252.20
Problem #2: Solving a Lump Sum Problem
Here is a lump sum problem. Lump sum problems are pretty
easy. Again, you need to look up a factor. Be sure to look up
the factor on a Present Value of a Lump Sum table.
Sometimes those tables are called Present Value of $1.
15%
1 2 3 4 5 6 7
Hopefully the factor you found is .65752 Here is all you
do to find the present value:
Present Value = .65752 x $5,000

Present Value = $3,287.60 (positive cash flow)

$5,000
PV = $3,287.60
Problem #3: Mixing An Annuity and a Lump Sum
Check out the following cash flows. If you look carefully,
you will see that there is an annuity for years 1-6 and a lump
sum at the end of the 7
th
year. The interest rate has been
changed to 12%.
12%
1 2 3 4 5 6 7
Solution: Find the present value of the annuity (12% & 6 periods)
Present Value = 4.11141 x $3,000 = $12,334.23

Next: find the present value of the lump sum ($12% & 7
th
period)
Present Value = .45235 x $10,000 = $452.35

Finally: simply add the two present values together for the final answer.
$12,334.23 + $452.35 = $12,786.58
$3,000 $3,000 $3,000 $3,000 $3,000 $3,000 10,000
PV = $12,786.58
Problem #4: A Late Bloomer Annuity
Although it looks different, this problem is similar to the problem we just did.
Below we have an annuity (equal payments & equal periods of time), but the
annuity begins at the end of year 3 and extends to the end of year 7. If you
count the number of payments, you would see that there are 5 payments of
$5,000 each. The first step is to find the present value of the annuity.
12% 1 2 3 4 5 6 7
Solution: Find the present value of the annuity (12% & 5 periods, not 7 periods)
Present Value = 3.60478 x $5,000 = $18,023.90

We are left with a lump sum of $18,023.90. Notice that it is placed at the end
of year 2. Now, just find the present value of a lump sum $18,023.90, 12%,
period 2
$5,000 $5,000 $5,000 $5,000 $5,000
$18,023.90
1 2 3 4 5 6 7

$18,023.90

The present value and final answer = .79719 x $18,023.90 = $14,368.47
Problem #5: Scattered Odd Amounts
Sometimes there will be cash flows that occur in different amounts and at
different times. The key is to treat them as separate lump sums and then
add each present value together.

12%
1 2 3 4 5 6 7
Solution:

Present Value of $2,500, end of year 2, 12% = .79719 x $2,500 = $1,992.98

Present Value of $4,000, end of year 3, 12% = .71178 x $4,000 = $2,847.12

Present Value of $3,500, end of year 5, 12% = .56743 x $3,500 = $1,986.01

Grand total and final answer = $6,826.11
$2,500 $4,000 $3,500

PV = $6,826.11
Problem #6: Mixing Positive and Negative Cash Flows
Often times when analyzing business opportunities, there are a combination of
positive and negative cash flows. For example, perhaps a business must invest
$3,000 for the first three years in order to receive $10,000 at the end of
the 4
th
and 5
th
years. Again, all cash flows are assumed to take place at the
end of each year.
12%
1 2 3 4 5 6 7
Solution:

PV of -$3,000 Annuity, 3 years, 12% = 2.40183 x -$3,000 = -$7,205.49

PV of $10,000, end of year 4, 12% = .63552 x $10,000 = $6,355.20

PV of $10,000, end of year 5, 12% = .56743 x $10,000 = $5,674.30

Grand total and final answer = $4,824.01

-$3,000 -$3,000 -$3,000 $10,000 $10,000

Putting it All Together
So what does this all mean? How do you use it to solve business problems?
Here are the steps:

#1. Determine the cash flows in regard to the business opportunity you are
analyzing and place the cash flows on a time line.

#2. Determine a rate of interest. A good place to start is the rate of return
you would like to earn. Add percentage points if the opportunity is very risky.

#3. Find the present value of all cash flows. Do not forget to distinguish
positive and negative cash flows.

#4. If the final result of your present value calculations is greater than
zero, the project might be worth doing. If the final result of your
present value calculations is less than zero, the business opportunity fails
the NPV test and the project might not be worth further consideration.

Following this slide are some practice problems and solutions.
Practice Problem #1: Converting to a Company Wide Software
System

During years one and two, a company is spending $5,000 each year on a new
computer software system. The company expects to save (positive cash flow)
$8,000 each year for years 3, 4, 5, & 6. Is the project worthy of
consideration if the company expects a 15% return on its investments?
Practice Problem #1: Solution

The following are the cash flows:

1 2 3 4 5 6 7
Solution:

PV of -$5,000 Annuity, 2 years, 15% = 1.62571 x -$5,000 = -$8,450.25

PV of $8,000 Annuity, 4 years, 15% = 2.85498 x $8,000 = $22,839.84
(The $22,839.84 is lands at the end of year 2 and must be treated as a lump sum)

PV of $22,839.84, end of year 2, 15% = .75614 x $22,839.84 = $17,270.12

Add up the results inside the boxes for the final total = $8,819.87

Since the end result is positive (greater than zero) the project passes the
NPV test and might be worthy of further consideration.
-$5,000 -$5,000 $8,000 $8,000 $8,000 $8,000

PV =
15%
Practice Problem #2: Adding a New Technology Department

A company has decided to add a new technology department. During year one
the cost will be $10,000. During years 2 7 the cost of operating the
department is expected to be $5,000 each year. During year 5, the
department will be up-graded. The upgrade will cost $4,000. This $4,000 up-
grade is an additional cost over and above the normal operating cost of
$5,000 during year 5.

The company expects to save (positive cash flow) $9,000 each and every year
for years 1 7. The company expects to earn a 10% rate of return on this
investment. Does the project pass the NPV test?
Practice Problem #2: Solution

The following are the cash flows:

1 2 3 4 5 6 7
-$10,000 -$5,000 -$5,000 -$5,000 -$5,000 -$5,000 -$5,000
-$4,000
$9,000 $9,000 $9,000 $9,000 $9,000 $9,000 $9,000
10%
Here is a technique that sometimes makes the problem easier.

Before you begin calculating the present values of the various cash flows,
sometimes you can simplify the problem by combining the cash flows for each year.
Here is what the cash flows would look like after combining cash flows.

1 2 3 4 5 6 7

-$1,000 $4,000 $4,000 $4,000 $0 $4,000 $4,000
Practice Problem #2: Solution

As indicated on the previous slide, here are the revised cash flows:
10%
1 2 3 4 5 6 7

-$1,000 $4,000 $4,000 $4,000 $0 $4,000 $4,000
There are a few different ways to go about this, but here is a straight forward
approach:

PV of -$1,000, lump sum, year 1, 10% = .90909 x -$1,000 = -$909.09

PV of $4,000 Annuity, years 2 - 4 (3 years), 10% = 2.48685 x $4,000 = $9,947.40
(the PV of the annuity lands at the end of year 1 and must be treated as a lump sum)

PV of $9,947.40, year 1, 10% = ,90909 x $9,947.40 = $9,043.08

PV of $4,000 Annuity, years 6 7 (2 years), 10% = 1.73554 x $4,000 = $6,942.16
(the PV of the annuity lands at the end of year 5 and must be treated as a lump sum)

PV of $6,942.16, lump sum, year 5, 10% = .62092 x $6,942.16 = $4,310.53




Practice Problem #2: Solution

Here are the results from the previous slide:
PV of -$1,000, lump sum, year 1, 10% = .90909 x -$1,000 = -$909.09

PV of $4,000 Annuity, years 2 - 4 (3 years), 10% = 2.48685 x $4,000 = $9,947.40
(the PV of the annuity lands at the end of year 1 and must be treated as a lump sum)

PV of $9,947.40, year 1, 10% = ,90909 x $9,947.40 = $9,043.08

PV of $4,000 Annuity, years 6 7 (2 years), 10% = 1.73554 x $4,000 = $6,942.16
(the PV of the annuity lands at the end of year 5 and must be treated as a lump sum)

PV of $6,942.16, lump sum, year 5, 10% = .62092 x $6,942.16 = $4,310.53

Combining the numbers in the boxes equals $12,444.52

$12,444.52 is greater than zero and so the project passes the NPV test and should be
considered further.



One Last Bit on How to Do NPV Analysis
1 2 3 4 5 6 7

10%
Look at the following cash flow. See if you can see something that is different
from the previous problems.

$1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000
The real difference between this problem and the others is that the cash
flows begin at the present time. In other words, the first $1,000 cash flow
happens immediately. What this means is that the very first cash flow is
already at the present value.

The moral of the story is that when a cash flow is listed at the beginning of
the time line, the amount is already at the present value and no additional
calculation are required for that first $1,000. See the next slide for more
info
A Payment at Time Zero. How to Solve It.
1 2 3 4 5 6 7

10%
Here is the same problem from the previous page.

$1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000


The first payment is
already at its
present value
because the
payment takes place
at the very start
(time zero) and so
for now we can leave
it alone.
The remaining payments form an annuity. Equal
payments over equal periods of time. Of the
remaining payments we have, 6 payments of $1,000,
@10%.
PV = $1,000 x 4.35526 = $4,355.26
The final answer:
The first payment + the PV of the annuity = final answer
$1,000 + $4,355.26 = $5,355.26
That is the end of Net Present Value Made Easy.

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