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“How To….” Understand and Use NPV in a Business Case

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During the development of our new business case writing master class I wanted to make sure that we looked into the  financial metrics that are often required to justify developing and launching new products. In our discussions with our clients and training participants the key financial measure that is required to justify whether a product initiative is approved or not is the NPV.

The NPV  (Net Present Value) is the forecast financial outcome of a new product initiative. Calculating it will firstly tell the business if the product initiative will return a benefit to the business relative to the cost of financing the investment, and secondly the NPV provides a standard yardstick by which to measure one initiative against another.

The concept is based on the way that the value of money changes over time.

For example, lets say that I have been asked to choose between being given either:

  1. Option 1 – $1000 today
  2. Option 2 – $1100 in 2 years

At first glance it looks like Option 2 is a better deal because I will get more cash in the hand. But I also need to consider what the value of Options 1’s $1000 will be in 2 years. This will depend on the interest rate applied to it.

Assuming an interest rate of 5% pa the $1000 will be worth $1050 ($1000*1.05=$1050) after 1 year and $1102.50 after 2 years ($1050*1.05=$1102.50).

So the FUTURE VALUE of Option 1 is $1102.50 versus Option 2’s $1100 if we wait for 2 years. So, I am better to select Option 1 $1000.

The NPV does this calculation in reverse. Instead of calculating the FUTURE VALUE of today’s money it converts all current and future revenue and costs into PRESENT VALUE. Again using the example above, the PRESENT VALUE of Option 1 is $1000, and PRESENT VALUE of Option 2 is $997.73. In addition to the monetary values being entered we also need the rate (called the Discount Rate) to be used and the number of years (or periods) to be calculated.

Below are some scenarios for the financial forecasts for a subscription service business case.

Scenario 1

There is a upfront investment of $100,000 and a steady marketing costs to grow the subscriber base, along with some per user and fixed costs to manage.

Acquisition costs New Customers Total Customers ARPU Cost per user Fixed Costs P/L
Year 0 -$100,000
Year 1 $100 100 100 $360 $100 $1,000 $15,000
Year 2 $100 200 300 $360 $100 $1,000 $57,000
Year 3 $100 300 600 $360 $100 $1,000 $125,000
Year 4 $100 400 1000 $360 $100 $1,000 $219,000
Year 5 $100 500 1500 $360 $100 $1,000 $339,000
Totals Total Subs 1500 Total P/L $655,000

In this company they require a discount rate of 10% to be applied to NPV calculations. This basically sets a minimum rate of return threshold for the business case financials and will filter out initiatives where the money spent would be better left in the bank to earn interest.

The NPV is calculated by discounting the Profit or Loss of each year by the interest rate and the number of years and then adding all the values together.

  • Year 0: -$100,000/(1+10%)^0 = -$100,000
  • Year 1 : $15,000/(1+10%)^1 = $13,636.36
  • Year 2 : $57,000/(1+10%)^2 = $47,107.44
  • etc…

So even  though the total profit is $655,000 the NPV for the project is $414,730.

Scenario 2

Here is another example where the upfront investment is lower but the acquisition costs are higher to bring in more customers in the early stages of the life of the project even though the revenue per user is higher. The total number of subscribers in both cases is the same.

Acquisition costs New Customers Total Customers ARPU Cost per user Fixed Costs P/L
Year 0 -$50,000
Year 1 $800 500 500 $400 $100 $1,000 -$251,000
Year 2 $600 400 900 $400 $100 $1,000 $29,000
Year 3 $500 300 1200 $400 $100 $1,000 $209,000
Year 4 $400 200 1400 $400 $100 $1,000 $339,000
Year 5 $300 100 1500 $400 $100 $1,000 $419,000
Totals Total Subs 1500 Total P/L $695,000

Here the total profit is $40,000 higher than the first scenario, but when we look at them with the NPV calculation we see that Scenario 2 is actually worse off with an NPV of $394,517.51. This is because the large costs of acquisition occur early in the project and have a higher impact on the present value vs the higher revenue towards the end of the 5 years.

So both projects would get the approval to proceed because their NPV was positive over 5 years with a discount rate of 10%, but to select the best project based on the forecasts above Scenario 1 is the best choice.

Scenario 3 – Negative NPV

The following scenario would not be approved.

Acquisition costs New Customers Total Customers ARPU Cost per user Fixed Costs P/L
Year 0 -$100,000
Year 1 $100 100 100 $185 $100 $1,000 -$2,500
Year 2 $100 200 300 $185 $100 $1,000 $4,500
Year 3 $100 300 600 $185 $100 $1,000 $20,000
Year 4 $100 400 1000 $185 $100 $1,000 $44,000
Year 5 $100 500 1500 $185 $100 $1,000 $76,500
Totals Total Subs 1500 Total P/L $42,500

Here the project appears to make an overall profit of $42,500 but when the NPV calculation is applied it results in a negative value of -$5974.35.

This means that at year zero the business is better off not not investing in the project.

Summary

Net Present Value (NPV) is a very important tool for comparing the value of different initiatives or projects. Make sure that you know what the discount rate is and the number of years to be compared. NPV illustrates that even though a product can deliver profit it does not mean that it is a good investment for the business.

Feedback

Please share in the comments how you use NPV’s. Do you use them? Do you calculate them yourself or is this done by a finance team?

Please add your feedback in the comments below.

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7 Comments

  • Billy Cedeno says:

    I read the article on NPV calculation and it was very helpful. I really appreciate sharing this online.


  • ERIC says:

    This is the best explanation of npv ever


  • Terry says:

    I’m with ERIC.
    As I am just about to embark on studies where NPV is used as a business measure, I found this article invaluable.


  • Bing57 says:

    Very clear explanation of NPV with useful, easily followed examples.


  • Lucy says:

    Thank you! I was struggling with when to choose n=0 and n=1, but feeling better now.


  • Sonia Schenkel says:

    Sonia S: currently studying this subject with insufficient explanation of the use. This has clarified the subject but I still have questions. Thank you for your help it is great.


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