Microsoft Office Tutorials and References

In Depth Information

If the NPV is positive, this indicates that the future cash flows provide a better rate of return than the specified

discount rate. The positive amount returned by NPV is the amount that the investor could add to the initial cash

flow (called
Point 0
) to get the exact rate of return specified.

As you may have guessed, a negative NPV indicates that the investor does not get the required discount rate, of-

ten called a
hurdle rate.
To achieve the desired rate, the investor would need to reduce the initial cash outflow

(or increase the initial cash inflow) by the amount returned by the negative NPV.

The discount rate used must be a single effective rate for the period used for the cash

flows. Therefore, if flows are set out monthly, you must use the monthly effective rate.

Definition of NPV

Excel's NPV function assumes that the first cash flow is received at the
end
of the first period.

This assumption differs from the definition used by most financial calculators, and it is

also at odds with the definition used by institutions such as the Appraisal Institute of

America (AIA). For example, the AIA defines NPV as the difference between the present

value of positive cash flows and the present value of negative cash flows. If you use Ex-

cel's NPV function without making an adjustment, the result will not adhere to this

definition.

The point of an NPV calculation is to determine whether an investment will provide an appropriate return. The

typical sequence of cash flows is an initial cash outflow followed by a series of cash inflows. For example, you

buy a hot dog cart and some hot dogs (initial outflow) and spend the summer months selling them on a street

corner (series of inflows). If you include the initial cash flow as an argument, NPV will assume the initial in-

vestment isn't made right now but instead at the end of the first month (or some other time period).

Figure 12-1 shows three calculations using the same cash flows: a $20,000 initial outflow, a series of monthly

inflows, and an 8% discount rate.

The formulas in row 9 are as follows:

B9: =NPV(8%,B4:B8)

C9: =NPV(8%,C5:C8)+C4

D9: =NPV(8%,D4:D8)*(1+8%)