Note: In an earlier version of this post, I had mistakenly used the purchase figure as the first value after rate. I have since been shown that the first value after rate is assumed to be the cashflow in period one, and have since made the correction.

NPV: What is it?

The NPV function is a useful way of calculating the Net Present Value of an investment, and is used to compare the worth of several potential future investments over a set number of equal time periods. Any future expected cash flows are discounted in such a way that the value of money in each period is considered equal (i.e. a dollar next year is worth just as much as a dollar today). If the NPV is a positive figure, the investor is set to receive a positive return.

=period_0+NPV(rate, period_1, period_2, …)

The NPV function consists of two main arguments (or inputs), which are ‘rate’ and ‘value’. Rate represents the expected discount rate of an investment, and is entered as a decimal (i.e. 4% would be entered as 0.04). Value represents the cash flows that are present in each period of the investment, and a new value is entered for each cash flow that occurs (the first cash flow would be entered as value1, second as value2, etc). Cash outflows are entered as negative numbers and cash inflows are entered as positive numbers. The formula assumes that all of the cash flows take place at the end of the period.

How do I use it?

As an example, let’s say that you purchase a machine that makes fluoro legwarmers (because, let’s face it, everyone loves the 80s and legwarmers are always stylish). You purchase the machine for $50,000 at the beginning of year one (which in this case would mean the end of Year 0), and determine that the discount rate for all future cash flows is 8%. For the first three years, the machine is expected to return you $12,000, $10,000, and $13,000 respectively.
To calculate the NPV, the above information would be entered into Excel like so:

This returns you a figure of -$19,995.68, which means that at the end of the third year the investment is generating a loss. This is because the initial cost of the machine has still not been recouped by the cash inflows that it has generated. From here, the investor can decide whether their investment period is reasonable (maybe 5 years is more appropriate?), or whether the idea is simply unprofitable.