The Importance Of NPV For Financial ModelSadaf Abbas
Creating a financial model in excel requires the use of a range of formulas and financial tools. Doing so helps make sure that your financial model stands viable and represents your business’s financial structure. Moreover, it also helps make sure that you’re able to determine your business’s value better.
While financial modeling excel doesn’t have to be accurate or represent the exact figures that occur in real life, it helps bridge the difference between the actual and what you have forecasted. Therefore, if you’re using the right methodologies, this becomes much easier for you. One of the main parts of a financial model is taking out the NPV of the business.
Now, you might be wondering why the Net Present Value (NPV) holds such immense importance in a financial model. Well, it can be said that the NPV financial model measures the time it will take to recover the project investment.
What Is NPV In A Financial Model In Excel?
The Net present value represents the discounted future cash flows for any project, business, or investment. While you would hope for the results always to be positive, that isn’t always possible. NPV showcases positive and negative results to help you understand whether a specific project or business would be beneficial for you or not.
Net present value is used for financial modeling in excel to determine the value of a particular venture or business. Keep in mind that you can use NPV for many things, which is not the only way to use it. You can use this formula to take out the NPV of any possible element that involves the use of cash flows. As long as you incurring some initial outlay and getting future cash inflows or outflows, you can easily discount these back in your financial model in excel using its formula.
What Is The Formula For NPV For Financial Model In Excel
That brings us to the formula of the Net Present Value. While it may seem highly confusing to someone who has no idea about the NPV, the application is pretty simple. You will find that the NPV formula is not difficult to understand. It denotes taking the present value of all future cash flows and then subtracting it with the initial investment to determine whether the project has a positive or negative NPV.
Let’s take a look at the formula so that it is easier for you to understand the concept of NPV.
As you can see here, Z1 represents cash flows from year 1, Z2 represents cash flows from year 2, r represents the discount rate, and X0 represents the outflow from the initial year of investment. These are simple and not so difficult to input into your financial model in excel. All you have to really do is make use of the already given formula in excel, and you will have your answer as soon as you enter in the details.
Why Is The NPV Used For Financial Model In Excel
So, why would you be using the NPV formula for your financial model in excel? The answer is simple; it makes calculations so much easier. As you go about creating your financial model in excel, you will have to undergo a series of steps to get to the cash flows. First, you will have to ensure that you have adequate data to help you with forecasting.
Moving forward, you will need to ensure that you have the right assumptions for your forecasts. With these, you get to create your income statement, financial position statement, and then ultimately your cash flow statement. The importance of NPV starts with cash flows.
To get to know whether or not a specific project or business will cover the initial cost of investment, the NPV proves to be highly relevant to measure this. It also helps you figure out whether you should carry out a specific project or business in the long run. If the project is offering you negative NPV, then the answer is pretty straightforward. You want to avoid moving forward with a project that offers you a negative NPV.
Another great thing about using NPV in excel is that you can account for irregular cash flows. The formula of XNPV allows you to consider all irregular cashflows present to give you the right discounted value for it.
Reasons For Discounting Cash Flows In A Financial Model
Why can’t you use the non-discounted cash flows to determine whether carrying business or project is good for you or not? Well, the problem is that over time, money loses its value. The NPV formula takes in the concept of the time value of money to understand what the real value of the cash flows will be at the current period.
It avoids giving you superficial values that won’t help you with making the right decision. Instead, it makes sure that you get the discounted values of all the cash flows in your financial model in excel. The best thing about using NPV in your financial model is that it gives you the value of what your future cash flows will be today. So, you can decide as to whether investing in such a venture is ideal for you or not.
Examples Of NPV In Financial Models
Here is a simple and easy example of how NPV works in your financial model in excel. To take on this project, you will have to make an investment of 100,000. The projection shows that this project offers you 20,000 over a period of 7 years. The discount ratio is 10%, and here is the calculation for the NPV.
According to the calculation, you can see that the NPV is positive. So, this shows that investing in this project is feasible for your business. Since it offers you a positive discounted cash flow and NPV, you can easily decide on going ahead with this project. Had this been negative, then you would’ve tried to steer clear of investing in such a project for your business.
Applying NPV In Your Financial Models
When applying NPV to your financial model in excel, you can do this in two methods. One is for when you’re making decisions about investing in a particular business. The other is about deciding on investing in a project for your already established business.
Real-world scenarios are always helpful. Check out some of our real-world case studies
Figuring out whether you should invest in a business or not is a difficult decision to make. You want to make sure that you’re looking over every aspect of the potential business before making any decisions. So, you will create a financial model to help you understand what its cash flows will be. The financial model is essential for every business that needs investment or seeking a loan. The numbers of the financial model are taken for a Business Plan
You can hire the CFO services of a financial analyst to help you prepare for this. It is highly relevant to get a good projection of the cash flows through which you will take out the NPV for your financial model in excel. Once you have the NPV in front of you, deciding whether you should start that particular business becomes easier. If it is positive, you are more inclined to go ahead with this business’s startup.
Next, we have NPV’s use for deciding whether or not you want to move forward with a particular project for your business. Carrying out the discounting factor model for your business will prove to be beneficial as it will show you whether investing in a particular project is worth it or not. Deciding whether you should go for a project depends on the NPV of the project. Even if the NPV comes to zero, you will be covering your initial costs, so the NPV will be called positive. You can use this by taking out the free cash flow and then using the hurdle rate or WACC to calculate the NPV of a project.
Advantages And Disadvantages Of NPV In Financial Model
The NPV in financial models comes with a range of advantages and disadvantages. While it helps determine whether or not it will be useful for the business, some drawbacks are associated with the concept.
- Accepts conventional cash flow patterns
- Considers risks and time value of money
- Provides a measure of profitability
- Reinvestment assumptions incorporated
- Sunk costs overlooked
- Doesn’t determine the required rate of return
- Gives optimistic projections
The pros and cons of using NPV in excel are not limited to this only. You will find more of these once you start incorporating it into your financial model in excel.
NPV vs. IRR
When talking about NPV, it is compared to the internal rate of return (IRR) quite often. The IRR is different than the NPV as it gives you the rate of return at which your future cash flows will result in zero. When deciding on any investment, you should make sure to take a look at both of these metrics. It will help you come up with a much more accurate answer.
NPV For Your Financial Model In Excel: Bottom Line
When it comes to taking out the NPV for your financial model in excel, you want to make sure you’re accurate. Hiring the right CFO service can make things easier for you. We, at Oak Business Consultants, are experts in providing you with consultation on such matters.