Do you face any difficulties while making financial decisions like where to invest? How much to invest? etc. Then do not worry, there are some methods or tools called net present value, and internal rate of return through which we can make our financial decisions easily and effectively.
Net present value is the method through which we can calculate the present value of our future returns.
By the internal rate of return method, we can predict the feature revenue of our investments.
So I will discuss all these tools, which helps you make faster decisions, and also grow your business.
WHAT’S IN IT
Definition of Net Present Value
Net Present value is a tool to calculate future returns of an investment’s present value. If you invested in a project $1000, that gives you a $50 return on monthly basics.
So after two years, you will generate $1000 profit from that investment, and you think it’s good, I will make double from my investment in just two years.
But remember the money you have right now, its value is more than what you get later. I mean to say the value of $1000 May decreases to $800 or $700 after two years.
It may decrease because of inflation. It means if currently, you are spending $1000 for groceries in a week then after two years because of inflation or whatever reason if the product’s price increases then the value of the currency automatically decreases then you have to pay more money for that product.
And we invest by not analysing those things then our loss can happen.
But the best thing is that the net present value method helps us to analyze those things and give us a direction for a better investment.
Determination and Formula of Net Present Value
To determine the net present value of a project or investment first, we have to estimate the feature’s all the cash flows and discounts them into present value.
And after that, we have to add all that cash flows and subtract that from our initial investment, and then we will get the net present value of our present investment.
If the net present value is more significant than zero, then we can invest in that project, and if the net present value is less than zero, then we should better not invest in that project.
If we have more projects to invest in, then we can choose the project which has a high net present value.
The formula for determining the net present value is
In this equation,” I “ is the initial investment, “CF” is the cash flow and “ i ” is the interest or discount rate, and “ t ‘ is the time in which the cash flows occur.
Let’s understand it more clearly by an example of a juice company and it wants to produce a new product. To know whether to invest or not, it has to conduct a net present value of that product.
Suppose the product managers decide to invest only $1,00,000 to produce that product and it wants to get a revenue of 10% on this investment.
And they estimate the cash flow of the first year is $30,000, and in the second year it is $50,000, and in the third year, it is $80,000.
Now find the net present value.
Here the initial investment “I” is = $1,00,000
And CF1is = $30,000
CF2 is = $50,000
CF3is = $80,000
And the interest rate” i “ is = 10%
Time “ t ” is = 1st year, 2nd year, 3rd year
So let’s find out the net present value by putting these values in the formula. And the formula is NPV= -I0+cft/(1+i)t
NPV = -$1,00,000+$30,000/(1.1) + $50,000/(1.1)2+ $80,000/(1.1)3
So here the net present value is greater than zero so, here the company can invest in the product.
Definition of Internal Rate of Return
This process is as same as the net present value process, but the internal rate of return always expresses itself in percentages. We use this process if we want to determine the discount rate.
So the internal rate of return is a process where we can estimate the profitability of an investment, or project and make a better decision whether to invest or not.
It means if we want to invest in any property, business, or anything, we can calculate how many percentages can we earn from that investment in the feature, and according to that, we can invest.
Determination and Formula of Internal Rate of Return
To determine the internal rate of return, we also have to use the formula of net present value.
The formula for the NPV and IRR is the same, but the calculation process is little different.
And the formula is NPV= -I0+cft/(1+i)t
To calculate the internal rate of returns, we have to assume the NPV is zero.
If we want to calculate the internal rate of return for one time, then it is effortless, but if we want to calculate for many years, then it may be a little confusing.
And it is also a time-consuming process. We have to put a different rate of the return value and check. We can only find the internal rate of return value when the equation’s final answer becomes “zero”.
Suppose first we put the value of ‘i” and solve the equation if the equation’s solution does not become zero, then we have to try for another value.
We should solve the equation at that time until its value does not become zero.
Let’s go back to the juice company’s example and find the internal rate of return.
And at that equation, we consider as the initial investment “I” is = $1,00,000
And CF1is = $30,000,CF2 is = $50,000,CF3is = $80,000, interest rate” i “ is = 10% and thew time “ t ” is = 1st year, 2nd year, 3rd year
So the formula of IRR is NPV= 0 = -I0+cft/(1+i)t
Now we find the internal rate of return by putting different “ i “ ‘s values and try to get a solution as zero.
And previously we put the value of “ i “ 10% and got a result of $28699, which is more than zero. So now we increase the value of “ i ” to 15%.
NPV = 0 = -I0+CF1/(1.15)+CF2/(1.15)2+CF3/(1.15)3
= -$1,00,000+$30,000/(1.15) + $50,000/(1.15)2+ $80,000/(1.15)3
= -$1,00,000 + $26086 + $37807 + $52601
Answer = $16494
This answer is also higher than zero so now again we have to change the value of “i “ and try.
If we use the value of “ i “ 20%, then it approximately becomes zero.
NPV = 0 = -$1,00,000+$30,000/(1.2) + $50,000/(1.2)2+ $80,000/(1.2)3
= -$1,00,000 + $25000 + $34722 + $46296
So, this is the internal rate of interest.
If you want to invest in a business, project, or anything, my suggestion for you is that you should use the net present value and internal rate of return methods to find the best project to invest in.
The main thing about these programs is that we can use these tools very easily in excel.
And one of the limitations of these tools is that they don’t use the real values, they use estimating values for this project. And if we don’t predict that value correctly, then it may cause some losses. But if we do it correctly, then these tools can help us to make a better decision in investing.
Also you can read our blog on Break-Even Analysis-Most Detailed Guide