Net Present Value (npv)

Net Present Value (NPV) is the difference of the present value of future cash flows which can get by the amount of cash investment and rental property that required in property purchase (James R Kobzeeff, 2008). Most companies calculate the NPV which forecasting the cash flows of a project and discounting them by using a discount rate that covers opportunity costs of capital.

For example, Harer Company is considering to buy a performing certain operation machine. The machine cost $5,000. The machine can use for five years. The machine has no scrap value during the end of five years period. Every year, the labor costs will reduce $1,800. Harper Company needs a minimum 20% pre-tax return on all investment projects. Should the company purchase the machines?

Harer Company must find out the cash investment now with $5,000 can be justify if it will reduce over the next five years by $1,800 each year. However the company can earn 20% return by investment but the cost reductions still not enough to cover the original cost. They must bring at least a return of 20% or the company would better stop investing money in other way. The stream of annual $1,800 cost savings can compare to the cost of new machine after discounted to its present value to determine whether the investment is desirable. Since Harer Company needs a minimum 20% return on all investment projects which the discounting process rate and is called discount rate.

Initial Cost $5,000

Project Life 5

Annual cost savings $1,800

Rate of return 20%

Item Years Cash Flows Factor (20%) PV

Annual cost savings 1~5 $1,800 2.991 $5,384

Initial Investment Present -5,000 1,000 -5,000

NPV $384

The company should buy the new machine according to the analysis. The cost savings present value is $5,384 for the required investment. The net present value of $384 by deducts the present value of investment from the present value of cost savings.