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NPV & RELATED FORMULAS

Net Present Value

Net Present Value(NPV) is a formula used to determine the present value of


an INVESTMENT by the discounted sum of all cash flows received from the project. The
formula for the discounted sum of all cash flows can be rewritten as

When a company or investor takes on a project or INVESTMENT , it is important to


calculate an estimate of how profitable the project or INVESTMENT will be. In theformula,
the -C0 is the initial investment, which is a negative cash flow showing thatmoney is going
out as opposed to coming in. Considering that the money going out is subtracted from the
discounted sum of cash flows coming in, the net present value would need to be positive in
order to be considered a valuable investment.

Example of Net Present Value


To provide an example of Net Present Value, consider company Shoes For You's who is
determining whether they should INVEST in a new project. Shoes for You's will expect to
invest $500,000 for the development of their new product. The company estimates that the
first year cash flow will be $200,000, the second year cash flow will be $300,000, and the
third year cash flow to be $200,000. The expected return of 10% is used as the discount
rate.
The following table provides each year's cash flow and the present value of each cash flow.

Year
0
1
2
3

Cash Flow
-$500,000
$200,000
$300,000
$200,000

Present Value
-$500,000
$181,818.18
$247,933.88
$150,262.96

Net Present Value = $80,015.02


The net present value of this example can be shown in the formula

When solving for the NPV of the formula, this new project would be estimated to be a
valuable venture.

Payback Period

The payback period formula is used to determine the length of time it will take to recoup the
initial amount INVESTED on a project or investment. The payback period formula is used
for quick calculations and is generally not considered an end-all for evaluating whether to
invest in a particular situation.
The result of the payback period formula will match how often the cash flows are received.
An example would be an initial outflow of $5,000 with $1,000 cash inflows per month. This
would result in a 5 month payback period. If the cash inflows were paid annually, then the
result would be 5 years.
At times, the cash flows will not be equal to one another. If $10,000 is the
initial INVESTMENT and the cash flows are $1,000 at year one, $6,000 at year two,
$3,000 at year three, and $5,000 at year four, the payback period would be three years as
the first three years are equal to the initial outflow.

Use of Payback Period Formula


There are a few drawbacks to the payback period formula that may warrant one to consider
using another method of determining whether to INVEST .
One issue is that the payback period formula does not look at the value of all returns.
Suppose a situation where there are two choices to choose from where INVESTMENT X
has a payback period of 1 year and INVESTMENT Y has a payback period of 2 years.
However, investment X will only return the initial investment whereas investment Y will
eventually pay double the initial investment. Given the additional information not provided
by the payback period formula, one may consider investment Y to be preferable. The

formula for the net present value method may be used to close this information gap in order
to properly evaluate the best choice.
However, it is worth mentioning that although the net present value method may be
preferable to determine long term profitability, the payback period formula helps with cash
flow analysis for short term budgeting. Suppose a situation where investment X has a net
present value of 10% more than its initial investment and investment Y has a net present
value of triple its initial investment. At first glance, investment Y may seem the reasonable
choice, but suppose that the payback period for investment X is 1 year and investment Y is
10 years. Investment Y could cause problems if the investment is needed sooner. An
analogy of this would be like banks where maintaining cash flows of their
investments(loans) is vital to their business.
Another issue with the formula for period payback is that it does not factor in the time value
of MONEY . The time value of money concept, as it applies to the payback period formula,
proposes that each future cash flow is worth less when compared to today's value. The
discounted payback period formula may be used instead to consider the time value of
money, however the discounted payback period formula takes away the benefit of making
quick calculations.

Present Value of Annuity

The present value of annuity formula determines the value of a series of future periodic
payments at a given time. The present value of annuity formula relies on the concept of
time value of money, in that one dollar present day is worth more than that same dollar at
a future date.

Rate Per Period

As with any FINANCIAL formula that involves a rate, it is important to make sure that the
rate is consistent with the other variables in the formula. If the payment is per month, then
the rate needs to be per month, and similarly, the rate would need to be the annual rate if
the payment is annual.
An example would be an annuity that has a 12% annual rate and payments are made
monthly. The monthly rate of 1% would need to be used in the formula.

Assumptions
The formula shown has assumptions, in that it must be an ordinary annuity. These
assumptions are that
1) The periodic payment does not change
2) The rate does not change
3) The first payment is one period away
If the payment and/or rate changes, the calculation of the present value would need to be
adjusted depending on the specifics. If the payment increases at a specific rate, the present
value of a growing annuity formula would be used.
If the first payment is not one period away, as the 3rd assumption requires, the present
value of annuity due or present value of deferred annuity may be used. An annuity due is an
annuity that's initial payment is at the beginning of the annuity as opposed to one period
away. A deferred annuity pays the initial payment at a later time.

How is the PV of Annuity Formula derived?

The present value of a series of payments, whether the payments are the same or not, is

When the periodic payments or dividends are all the same, this is considered a geometric
series. By using the geometric series formula, the formula can be rewritten as

This equation can be simplified by multiplying it by (1+r)/(1+r), which is to multiply it by 1.


Notice that (1+r) is canceled out throughout the equation by doing this. The formula is now
reduced to

The P's in the numerator can be factored out of the fraction and become 1. The 1's in the
denominator of the formula are subtracted from one another. After making these
adjustments, the formula is simplified to the present value of annuity formula shown on the
top of the page.

Equivalent Annual Annuity

The equivalent annual annuity formula is used in capital budgeting to show the net present
value of an INVESTMENT as a series of equal cash flows for the length of the INVESTMENT
. The net present value(NPV) formula shows the present value of an investment that has
uneven cash flows. When comparing two different INVESTMENTS using the net present
value method, the length of the investment (n) is not taken into consideration. An
investment with a 15 year term may show a higher NPV than an investment with a 4 year
term. By showing the NPV as a series of cash flows, the equivalent annual annuity formula
provides a way to factor in the length of an investment.

How is the Equivalent Annual Annuity Formula Useful?

An example of how the equivalent annual annuity formula may be useful is comparing
twonew projects where one project has a 15 year term and the other has a 4 year term.
Assume that both projects have the same NPV. The 4 year project will receive
the returnsooner so it will show a higher cash flow when using the equivalent annual
annuity formula. In real life, comparing two INVESTMENTS will not always be so obvious
and the formula should be applied.
Another way of explaining the usefulness of the equivalent annual annuity formula is that
an INVESTMENT with a shorter life span can be reinvested and the earnings on the
reinvestment is not taken into consideration when using the NPV formula. The equivalent
annual annuity formula provides a comparison relative to time which eliminates the need for
considering reinvestment with the same earnings as the current investment.

How is the Equivalent Annual Annuity Formula Derived?


The equivalent annual annuity formula uses the annuity payment formula for when present
value is given. Net present value replaces present value to give relevance to the use of the
equivalent annual annuity formula.

Example of the Equivalent Annual Annuity Formula

Using the prior example of comparing one project with a 4 year term and another project
with a 15 year term, the NPV of the 4 year project is $100,000 and the NPV of the 15 year
project is $150,000. The rate used for both is 8%. Putting the variables of the 4 year
project in the equivalent annual annuity formula shows

which returns an equivalent annual annuity of $30,192.08.


Putting the variables of the 15 year project into the equivalent annual annuity formula
shows

which returns an equivalent annual annuity of $17,524.43.


Comparing these two projects, the 4 year project will return a higher amount relative to the
time of the INVESTMENT . Although the 15 year project has a higher NPV, the 4 year
project can be reinvested and have additional earnings for the 11 years that remain on the
15 year project.

Discounted Payback Period

*Assumes cash flows are equal


**See below for simple and uneven cash flows version

The discounted payback period formula is used to calculate the length of time to recoup
anINVESTMENT based on the INVESTMENT'S discounted cash flows. By discounting each
individual cash flow, the discounted payback period formula takes into consideration the
time value of money.
The discounted payback period formula is used in capital budgeting to compare a project or
projects against the cost of the investment. The simple payback period formula can be used
as a quick measurement, however discounting each cash flow can provide a moreaccurate
picture of the investment. As a simple example, suppose that an initial cost of a project is
$5000 and each cash flow is $1,000 per year. The simple payback period formula would be
5 years, the initial investment divided by the cash flow each period. However, the
discounted payback period would look at each of those $1,000 cash flows based on its
present value. Assuming the rate is 10%, the present value of the first cash flow would be
$909.09, which is $1,000 divided 1+r. Each individual cash flow would then be discounted
to its present value until it is determined how long it would take to recoup the original
$5,000.

Example of the Discounted Payback Period Formula


Using the prior example of a project that costs $5,000 with $1,000 annual cash flows.
Assuming the company uses a discount rate of 10%, the discounted payback period for this
example would be calculated based on the following equation:

The equation for this example would be reduced to:

which results in a discounted payback period of 7.273. Although this formula calculates
results with decimals, it is important to consider that there may be a slight difference due to
rounding and more importantly, that there may not be a such thing as a partial cash inflow.
This may warrant rounding up to determine how long it would take to recoup the
initial INVESTMENT .

Alternative Discounted Payback Period Formula


The formula listed at the top of the page assumes that each cash flow is equal. In many
cases, the cash flows will not be equal. The simple version of the discounted payback period
formula is:

This is not as much a formula, as a way of explaining that the discounted cash flow method
discounts each inflow until net present value equals zero.
Another method to simplify the calculation when cash flows are even is to use a table for
the present value of annuity factor in order to solve n. The need to solve for n in the present
value of annuity formula will be further explained in the following section.

How is the Discounted Payback Period Derived?


The formula shown at the top of the page assumes that all cash flows are equal. If all cash
flows are equal, then the INVESTMENT return is simply an annuity. The point of the
discounted payback period formula is to calculate how long before the present value equals
the initial investment(NPV = 0). Thus, since PV of the annuity equals the initial investment,
solving for n, the number of periods, based on the present value of annuity formula can be
used. The only difference between solving for n based on the PV of annuity formula and the
formula shown at the top of the page is substituting PV for the initial investment since they
are both equal.
As stated in the prior section, the process of calculating the discounted payback period
when all cash flows are equal could be simplified by using a present value of annuity table
to calculate n.
If the cash flows are uneven, then the longer method of discounting each cash flow would
be used.