Net Present Value Analysis is a financial cash flow analysis technique that helps in project selection. Moreover, NPV project selection criteria falls under the classification of benefit measurement method. Further, NPV analysis uses discounted cash flow technique to assess project profitability. In fact, major advantage of net present value method is that it uses the concept of time value of money.
My post Project Selection Methods Top 5 Criteria especially covers theory of Net Present Value technique in great detail. However, this post describes the essential NPV calculation steps. Moreover, this post will also cover some suggested PMP exam question as a study guide.
Net Present Value Example Problem
Let us consider a npv example problem in order to demonstrate how this technique helps in project selection. To begin with, assume a project that requires an investment of INR 20,000. Further consider risk free rate of return is 8%. The following paragraph lists future cash flows of the project.
- First year INR 5,000
- Second year INR 6,000
- Third year INR 8,000
- Fourth year INR 7,000
- Fifth year INR 4,000
Another important aspect of npv calculation is that it is independent of currency. In the following example I have used INR you can replace it with any currency of your choice.
Net Present Value Formula
The following mathematical equation represents net present value formula.
Net Present Value Method Calculation Steps
The following paragraphs enumerates steps involved in calculating net present value (npv).
NPV Calculation Step 1
- To begin with firstly arrange all future cash flows corresponding to each year of receipt. The following table illustrates this. Another key point to remember is that NPV calculation is not dependent of currency. Hence in my example I have not used any currency symbol.
First Year | Second Year | Third Year | Fourth Year | Fifth Year | |
Future Cash Flow | 5000 | 6000 | 8000 | 7000 | 4000 |
NPV Calculation Step 2
- Next step is to calculate present value of each of the future cash flow
- Mathematical expression of Present Value (PV) is;
- Where; k = discounting factor / interest rate and N = Number of time periods
First Year | Second Year | Third Year | Fourth Year | Fifth Year | |
Future Cash Flow | 5000 | 6000 | 8000 | 7000 | 4000 |
Present Value (PV) | 5000 / (1+0.08)
5000 / 1.08 |
6000 / (1+0.08)^2
6000 / 1.17 |
8000 / (1+0.08)^2
8000 / 1.26 |
7000 / (1+0.08)^3
7000 / 1.36 |
4000 / (1+0.08)^4
4000 / 1.47 |
NPV Calculation Step 3
- Now add all the present values of future cash flows.
- The following table illustrates steps involved in calculating present value of future cash flows.
First Year | Second Year | Third Year | Fourth Year | Fifth Year | |
Future Cash Flow | 5000 | 6000 | 8000 | 7000 | 4000 |
Present Value (PV) | 5000 / (1+0.08)
5000 / 1.08 4630 |
6000 / (1+0.08)^2
6000 / 1.17 5144 |
8000 / (1+0.08)^2
8000 / 1.26 6351 |
7000 / (1+0.08)^3
7000 / 1.36 5145 |
4000 / (1+0.08)^4
4000 / 1.47 2722 |
NPV Calculation Step 4
- Now that you have investment value and the net present value of future cash flow. This information will help you to calculate NPV.
- In order to calculate NPV subtract investment value (cash outflow) from Sum of Present Value (PV) of all future cash flows.
- You will be left with either a positive or a negative value.
Sum of Present Value | 23,992 |
Investment Value | 20,000 |
Net Present Value (NPV) | 23,992 – 20,000 = 3,992 |
NPV Calculation Step 5
- Finally analyse the NPV value that you have.
- In order to arrive at the project selection decision the following criteria is followed.
- Accept the project if NPV is greater than zero. (NPV > 0 Accept).
- Reject the project is NPV is less than zero. (NPV < 0 Reject).
- While comparing two projects always select the project with a higher NPV.
The following image depicts all the steps involved in calculating Net Present Value (NPV) .
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Also read: Project Selection Methods Top 5 Criteria
Net Present Value Analysis PMP Exam Questions
As a matter of fact, Project Management Professional (PMP) certification examination has never asked for detailed NPV calculation. However, it is important to understand the steps. NPV PMP exam questions are of the following types
NPV PMP Exam Question
Project A has NPV of INR 50,000 and takes 1 year to complete. Project B has NPV of INR 75,000 but takes 2 years to complete. Which project will you choose?
NPV PMP Exam Question Solution
Answer: Select Project B
When we have to select two projects then always choose the project with higher NPV. In fact, the element of time has no selection basis here as npv methods caters for time value of money.
Summary
As shown above net present value calculation steps are simple to understand. To summarize NPV project selection technique is an important financial analysis tool that every project manager should be aware of. However, PMP exam requires examinees to know how to apply fundamental knowledge to project selection.
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