In my last blog post I discussed a financial tool, Net Present Value (NPV). In this post I’ll use an example of how NPV works. You can refer back to this information whenever you need to make a large purchase decision.

In order to perform the calculation you will need to know:
1. The discount rate (usually a target return on investment rate or the current market rate),
2. The number of years the project/equipment is to last, (note: MS Excel doesn’t require this item)
3. The cost of the initial investment, i.e., cost of equipment or new project,
4. The estimated the cash flow for each year of the project or cost savings from the more efficient equipment (or increased revenue).

Let’s assume a discount rate of 10%, 10 years, initial cost of $100,000 and annual cost savings for 6 years of $20,000. Note: Input the initial costs as a negative number, i.e., -100,000 in your formula. Using MS Excel, find the Finance formula function for NPV. It will ask for the rate, input this as a percent, such as .10. Then it shows a field for Value1, input this as a negative number, as discussed above, -100000 (this is your cash outlay). Then input the value 20000 in the Value2 through Value7 slots (for the $20,000 of annual savings for six years). Using the NPV formula this equipment returns a value of ($11,773), so this equipment is actually costing more money than it is saving. For this purchase to provide a positive value the annual savings of $20,000 would need to occur for 8, not 6 years or the interest rate would need to be about 5% instead of 10%. This MS Excel calculation took less then 2 minutes to complete!

Of course these figures are based on estimates, so you need to be as realistic as possible. Since you use estimates in order to calculate the Net Present Value keep in mind that the results are not guaranteed. However, this is true for any similar evaluation of future outcomes. It is also helpful to perform two calculations; one as a best case scenario and one as worst case scenario. Combine the results from these two estimates and evaluate if the purchase would still show a net positive result.

Many business owners rush out and make purchasing decisions without doing any analysis on whether or not that asset will add value to their business. While many purchases cannot be avoided, such as repairs or replacement of old equipment, it is still worth the time to assess the cost and/or benefit of the purchasing decision.