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ndamental finance and accounting concepts.

 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 -$100,000 $25,000 $25,000 $25,000 $25,000 $25,000

Machine B Time
0 1 2 3 4 5
Cash flows -$75,000 $20,000 $20,000 $20,000 $20,000 $20,000

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 -$5,230.33 NPV $815.74

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.
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 Net
onePresent Value Function
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 fl -$75,000 $20,000 $20,000 $20,000 $20,000 $20,000 10%

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

Discount Rate

Future Cash flows

Assumption that cash flows occur at

the end of the period