Net Present Value (NPV) Calculation with 15% Discount Rate: Step-by-Step Guide with Example

Net Present Value (NPV) Calculation: Step-by-Step Guide with Example 2

Net Present Value (NPV) Calculation with 15% Discount Rate

An initial investment of $400,000 is made in an IT project, expected to generate the following cash inflows over the next five years:

Question: Net Present Value (NPV) Calculation with a 15% Discount Rate

Year	Expected Cash Inflow ($)
1	70,000
2	120,000
3	140,000
4	140,000
5	40,000

An IT project requires an initial investment of $400,000 and is expected to generate the following cash inflows over the next five years:

Will the project be financially viable based on the NPV calculation?

Solution Approach

1. Calculate the Present Value (PV) of each year’s cash inflow using the 15% discount rate.
2. Sum up the PV of all years to determine the total present value of cash inflows.
3. Compute NPV using the formula: $$NPV = \text{Total Present Value of Cash Inflows} - \text{Initial Investment}$$
4. Decision Rule:
   • If NPV > 0, accept the project (profitable).
   • If NPV < 0, reject the project (not profitable).

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Year	Cash Inflow ($)	Present Value (PV) Formula	Discounted Cash Flow ($) at 15%
1	70,000	70,000 / (1.15)^1	60,869.57
2	120,000	120,000 / (1.15)^2	90,737.24
3	140,000	140,000 / (1.15)^3	92,052.27
4	140,000	140,000 / (1.15)^4	80,045.45
5	40,000	40,000 / (1.15)^5	19,887.07

Total Present Value of Cash Inflows

Total Present Value	Result
$ 60,869.57 + $ 90,737.24 + $ 92,052.27 + $ 80,045.45 + $ 19,887.07 =	$ 343,591.6

Total PV of cash inflows ≈ $343,591

NPV Calculation

NPV	Result
343,591 - 400,000 =	$ -56,408

Decision Rule

Condition	Decision
If NPV > 0	Accept the project (Profitable)
If NPV < 0	Reject the project (Not Profitable)

Since the NPV is negative (-$56,408), the project should be rejected as it would result in a financial loss.

If the opportunity cost of capital (discount rate) is 15% per annum, determine whether the project should be accepted or rejected using the Net Present Value (NPV) method.

Key Insight

Although the cash inflows remain the same as in the previous example (where the discount rate was 8%), the NPV has changed due to the increase in the discount rate (opportunity cost of capital). This demonstrates that NPV is highly dependent on the discount rate, making it a crucial factor in investment decisions.