Most people assume that procurement or commercial people are good at Maths or NPV calculations, that’s not strictly true. I passed my financial module in my MBA but that does not mean I am good at it, in fact, I did all of my course calculations in excel!
What is ‘Net Present Value – NPV’
Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of a projected investment or project.
The following is the formula for calculating NPV, I only passed my module because I did the calculation in excel, so if you struggle I recommend you use the same. The discount rate used by Treasury is 3.5% so if in doubt use that as the discount rate.
Here is the formula for calculating NPV
where
Ct = net cash inflow during the period t
Co = total initial investment costs
r = discount rate, and
t = number of time periods
There are other calculations other than NPV that can be used to calculate a rate of return.
Pay Back Period
This is a little easier to calculate- payback period is the length of time required to recover the cost of an investment.
Accounting Rate of Return
Accounting rate of return, also known as the Average rate of return, or ARR is a financial ratio used in capital budgeting. The ratio does not take into account the concept of time value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return.
| ARR = | Average Accounting Profit | |
| Average Investment |
Internal Rate of Return
Internal rate of return (IRR) is a metric used in capital budgeting measuring the profitability of potential investments. Internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on the same formula as NPV does.
My top tip is to work closely with your finance friends i.e. the accountant who can do these calculations for you or at least double check and also excel is your best friend! If all else fails there are websites that do the calculation for you!
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