Do you want to know whether an investment yields sufficient returns or do you want to know whether a business to be bought is in a favorable financial position? Then there are several ways to quickly find out. The net present value is one of them.
Net present value: what is it?
Net present value is about the sum of all future cash flows. You calculate it by subtracting the present value of the future costs from the present returns. This shows very quickly whether the return on the business to be bought is greater than the purchase.
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The big advantage of this method is the time factor, because the value of money depends on inflation, purchasing power, etc. A disadvantage is that projects or purchases of different sizes cannot be easily compared due to this time preference. Other disadvantages are that the calculation does not take into account any hidden costs and the interest rate is uncertain for investments in the far future.
How do you calculate net present value?
You can calculate the net present value of a business using the time period and the cost of capital (or interest rate).
The formula for net present value is as follows:
NPV = future value / ((1+i)^t), where i is the cost of capital and t is the period over which you consider the investment or purchase.
Actually, anyone can fill in a formula, but the interest rate in the formula largely determines the outcome of the formula. And with the choice of the cost of capital, you are making a prediction of future capital, interest and inflation trends. If you have no experience with this yourself, ask a financieel adviseur for advice.
Sample calculation
Imagine a business is offered for sale that you are interested in. For €150,000, you can call yourself the new owner. The company's annual cash flow is €30,000 and the annual cost of capital is 7%. The quick NPV method determines whether you will regret this purchase in one year's time or whether it will allow you to arrange a nice expansion. Entering it into the formula gives an NPV of: 30,000 / (1+0.07)^1 = 28,037 euros.
The present value of the investment is the net present value minus the investment amount. So in this case, 28,037 - 150,000 = - €121,963. Over one year, all things being equal, you can only conclude that your NPV is smaller than assumed in principle. The good news is that you don't buy a business just to sell it again after one year; then your payback period is simply too short.
