This post is written by Paramdeep.
Today, let us learn how to use NPV() function in Excel & create a simple financial model.
NPV – Introduction:
If you are dealing with cash and valuations, you are bound to have come across the NPV function. If you don’t know the assumptions behind the same, I bet it could cost you your job!
Let’s take a simple project – You buy a MSFT stock for USD 100. You receive a dividend of USD 10 in the first year, USD 20 in the second year, USD 40 in the third year and then you sell it out for USD 140. If you could have alternatively put this money in bank at 10% interest rate, have you gained anything?
How do you model this in excel? In this tutorial we understand how you can use NPV to do this analysis and what kind of pitfalls you can land into!!
What is the NPV() function
Simply speaking, NPV function calculates present value of your cash flows. Let’s take a simple example first –
You invest $100 in a bank, which pays 10% interest
- What is its value 1 year down the line?
- I am sure, you don’t need any coffee to get that value – 100 x 10% is the interest and 100 is the principal that you had. So the value 100 x (1+10%) = 110
- What about 2 years?
- Simple 100 x (1 + 10%)^2 = 121
- So, if I were to ask you, the present value of a cash flow of 121, that you were to get 2 years down the line at 10% interest?
- Again simple, you told me initially, it was $100
NPV does exactly that – gets you the present value of your cash flows
The function is simple, it does all the difficult calculations for you and gets you the solution!
Beware – The function has its own assumptions!
Though the function is quite convenient, but it has its own pitfalls. And in my modelling experience I have seen a lot of people making that mistake! Lets model the situation described in the beginning (The MSFT Case). The cash flows are given to you as:
Let us see, internally what we get by modelling the NPV from the first principles and using the NPV function
You can clearly see that there are two ways of using NPV function (and each has its own assumption!)
So what is happening internally?
Usually when we start a project, we assume that the investment is made upfront (On day 0). Then the revenues, costs and the cash would start flowing in. Since the investment is made on day 0, it should not be discounted.
But when you use the NPV function, excel internally makes an assumption that even the first cash flow is at the end of the year (Per se, this is not wrong, but in normal circumstances, you make the payment upfront!).
So the right usage of the function would be to add the first cash without discounting and then use the NPV function to discount the rest of the cash flows.
If you just use the NPV function on all the cash flows, then the inherent assumption is that even the first cash flow is at the end of the year.
Few other ways of calculating NPV
When you are dealing with cash flows and valuations (typically that is when you come across the functions like NPV, etc) even small mistakes cost dear. You want to make sure that you are as accurate as you can ever be. At that point of time, if the cash is not flowing at the year ends, you can use a more powerful function in excel – XNPV. You can show it the cash and the exact dates and it would calculate the exact NPV for you. People don’t often use it as they don’t know the exact dates of cash flow!
How do you calculate the discounted cash values in your models?
I know the easiest way would be to use the NPV function. It is easy to use but at the same time could be tricky. So how do you implement such functionality in your models?
Templates to download
I have created a template for you, where the subheadings are given and you have use the functions to get the right values for you! You can download the same from here. You can go through the case and fill in the yellow boxes. I also recommend that you try to create this structure on your own (so that you get a hang of what information is to be recorded).
Also you can download this filled template and check, if the information you recorded, matches mine or not!
For any queries regarding the cash impact or financial modeling, feel free to put the comments in the blog or write an email to firstname.lastname@example.org
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Learn more about Financial Modeling:
Go thru these articles to learn more about Excel Financial Modeling:
- Excel Financial Modeling – 6 part tutorial
- Introduction to Project Finance
- Using MOD() function to implement frequency escalation in Excel
- Creating a P&L Reporting Model in Excel – 6 part tutorial
The article is written by Paramdeep from Pristine.
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