How It Works
The formula for NPV is:
NPV = (Cash inflows from investment) – (cash outflows or costs of investment)
Let's assume Company XYZ wants to buy Company ABC. It takes a careful look at Company ABC's projections for the next 10 years. It discounts those projected cash inflows back to the present using its weighted average cost of capital (WACC) and then subtracts the cost of purchasing Company ABC.
[To learn how to calculate present value (PV), be sure to read A Primer on Present Value and Its Many Uses]
Cost to purchase Company ABC today: $1,000,000
Present value (PV) of cash flows from acquiring Company ABC:
Year 1: $200,000
Year 2: $150,000
Year 3: $100,000
Year 4: $75,000
Year 5: $70,000
Year 6: $55,000
Year 7: $50,000
Year 8: $45,000
Year 9: $30,000
Year 10: $10,000
Total: $785,000
Now that we know the total cash flow for the next 10 years (the total cash inflows from the investment), along with total cost of the investment in Company ABC, we can use the formula to calculate NPV:
Net Present Value (NPV) = $785,000 - $1,000,000 = -$215,000
At this point, management for Company XYZ would use the net present value rule to decide whether or not to pursue the acquisition of Company ABC. Because the NPV is negative, they should say, "No."
