Hello friends, welcome to Motivational Banker! Today we are going to learn an advanced and essential concept of Net Present Value, also known as NPV.

Without wasting any time, let’s dive straight into the topic. We’ll understand NPV step-by-step with the help of an example.

Feel free to watch the video to listen in Hindi or read the blog in English –

Understanding NPV with a Case Study

Imagine a company wants to invest ₹5,00,000 to purchase a machine (or a car). After 5 years, the company plans to sell this machine at a salvage value of ₹80,000 (scrap value). During these 5 years, the machine will generate annual cash flows as follows:

The cost of capital (discount rate) is 10%. Now, our goal is to calculate the Net Present Value.

How to Calculate NPV?

1. Discount the Cash Flows:
   Since the money will be earned in the future, we need to convert its value to today’s terms. This process is called Discounting, and we use the formula:

   Discount Factor = 1 / (1 + r)^n​
   
   Here, r is the discount rate (10%) and n is the year. For example:

   • Year 1: 100/110=0.909
   • Year 2: 100/121=0.826, and so on.
2. Multiply Cash Flows with Discount Factors:
   Multiply each year’s cash flow by its respective discount factor to get the Present Value (PV) of that year’s cash flow.

   Detailed Calculation

   Year	Cash Flow (₹)	Discount Factor (10%)	Present Value (₹)
   1	1,50,000	0.909	1,36,350
   2	1,80,000	0.826	1,48,680
   3	2,00,000	0.751	1,50,200
   4	2,50,000	0.683	1,70,750
   5	3,00,000	0.621	1,86,300

   Total PV of Cash Flows = ₹7,92,280

3. Add Salvage Value:
   The machine will be sold for ₹80,000 at the end of the 5th year. The present value of this salvage value is:
   80,000 × 0.621 = 49,680

   Total Present Value of Cash Inflows = ₹7,92,280 + ₹49,680 = ₹8,41,960

4. Deduct the Initial Investment:
   The machine costs ₹5,00,000. To get the NPV:
   
   NPV = Total PV of Inflows − Initial Investment
   NPV = 8,41,960 − 5,00,000= ₹3,41,960

What Does the NPV Mean?

The Net Present Value tells us whether an investment is profitable. In this case:

• A positive NPV (₹3,41,960) means the investment will generate profit and is a good decision.
• If NPV was negative, the investment would not be worthwhile.

Why is NPV Important?

1. Decision Making: If there are multiple machines or projects, calculate the NPV for each. The project with the highest NPV should be selected.
2. Time Value of Money: NPV considers the value of money over time, which makes it a reliable decision-making tool.
3. Clear Picture: It helps businesses see the net benefit after accounting for costs and future cash inflows.

Final Thoughts

Today we’ve learned what NPV is and how to calculate it. Remember:

• NPV = Present Value of Cash Inflows – Present Value of Cash Outflows
  By converting future cash flows into today’s value, businesses can make informed investment decisions.

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