Key Concept: Net Present Value (NPV)
Updated: Jul 10, 2020
Let’s assume that your client is looking to invest in a new venture. They might be thinking about setting up a new location (if they are a retailer), drilling a new well (if they are an oil producer) or launching a new consumer product to the market (if they are an FMCG manufacturer). How would you advise them whether or not to make the investment?
NPV to the rescue! The NPV (Net Present Value) calculation helps us compare apples to apples, by converting the future multi-year benefits and costs of the investment into today’s cash value. This is because money generally loses value over time (due to inflation), and because future cash flows are riskier than cash in your pocket today (duh!).
NPV is calculated as the sum of discounted cash flows, where the multi-year benefits minus costs are “discounted” with a “discount rate”. Generally, for the "discount rate" we would use the firm’s risk-adjusted weighted average cost of capital (WACC). It sounds complicated, but it simply denotes the minimum return on investment that the client is willing to accept.
Companies establish the minimum ROI after considering many factors such as sources of capital (e.g., equity, debt, and working capital) and expected returns on other investments. You are likely to get it as an assumption from the interviewer. If not, assuming a 10% discount rate is a good rule of thumb.
If you are wondering, how are you going to calculate NPV using this formula without excel or in the very least a calculator – relax! In 95% of case interviews, you would be able to use the much simpler perpetuity formula:
Note:
g stands for the growth rate of the cash flows, if these are, for example, linked to the inflation rate.
Perpetuity doesn’t mean forever, but with a high enough discount rate, cash flows beyond year 20 are actually pretty worthless. At 10% discount rate: (1+10%)^20 = 6.7, meaning that the cash flows in 20 years are worth 85% less (1-1/6.7) than their value today, and thus in most cases can be disregarded.
A typical case interview question would then be stated as follows. Your client is looking to invest $1m today, in developing a new product that would generate $150k per year in revenue in perpetuity, at a 50% gross margin. The client’s cost of capital is 10% per year. Should they go ahead?
NPV = -1 + (0.15 * 50%) / 0.1 = -0.25m
NPV is negative so the client shouldn’t make the investment unless they are able to improve the gross margin or reduce the cost of capital.
NPV calculation can also help you figure out whether taking a job with that hot new startup is worth it. Let’s assume that you are a great software engineer, and can earn $150,000 per year at Google, Facebook, etc. or you can join a new startup, and earn $50,000 per year, while compensated with stock options that could be worth $2,000,000 in 10 years, assuming the startup is sold for $100m. Therefore, effectively you are “losing” $100k a year for 10 years, with the hope of earning $2m in 10 years.
How would you set the discount rate? The “investment” in a start-up is significantly riskier than putting money in a savings account, so using the current savings rate (at c.1%) would be underestimating the risk. The company can close in year 3 or worse, in year 9! How much riskier is it? Clearly, it is hard to say upfront, but let’s assume that it is 50% riskier than investing the money in S&P500 (probably a bit too optimistic!). S&P500 long term returns are ~8% p.a., so we can choose a discount rate of 12%.
Here is the schedule of the cash flows:
NPV comes out positive, but is highly dependent on choosing the right discount rate, for your risk appetite and the particular venture. For example, at a 15% discount rate, this won’t be a worthwhile investment / job offer. Next time you are considering taking a pay cut to join a start-up, use NPV as your negotiation tool!
You can practice NPV related questions and other key concepts with our Mental Math quizzes (select the Business Concepts one). Want to try a full business case with NPV calculation? Book a coaching session and get expert feedback on your performance.