3-2-2-2 Net present value

The Payback period method ignores the time value of money, i.e. cash flows are not discounted. A method that takes the time value of money into consideration is the Net Present Value.

In this method you compare the initial investment with the future clash flows after discounting those cash flows using the minimum return the company expects to earn and any inflation adjustments.  You can use the formula attached here net-present-value to determine the NPV  but it is equally easy to implement it in Excel

Suppose a project requires an initial investment of $450,000. The project has an expected useful life of five years and the company expects  a net cash flow of $150,000 for each of the five years. The minimum expected return is 12% and inflation is expected to average 3% of the next five years. What is the Net present value of the project?  Click here to see the solution npv-example

Since the NPV is > 0, the project is worth funding

Question: What will cause the NPV to change? Will the NPV be higher or lower if the expected return is increased? You can experiment by inserting different values into the return cell.

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