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Net present value

Edexcel IAL Accounting · WAC12 Corporate and Management Accounting

£1 received in five years is worth less than £1 today. Net present value discounts each future cash flow back to today's value and compares the total with the cost of the investment.

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Time value of money

Money received sooner can be invested to earn a return, and inflation and risk reduce the value of later money. So future cash flows are multiplied by a discount factor for the required rate of return (the cost of capital):

Discount factor for year n at rate r = 1 / (1 + r)ⁿ

WAC12 papers print the factors, rounded to 3 decimal places (for example at 10%: 0.909, 0.826, 0.751, 0.683, 0.621). Use the printed factors: examiners penalise calculating a factor and then using a different one.

The NPV method

1. List the net cash flows each year: cash inflows (sales receipts, residual or scrap value, release of working capital) less cash outflows (running costs).

2. Exclude depreciation: it is not a cash flow (a common examiner-reported error). Also ignore sunk costs and apportioned fixed costs that do not change.

3. Year 0 is the initial cost, not discounted (factor 1.000).

4. Multiply each year's net cash flow by its factor to get the present value.

5. NPV = total present values of inflows - initial cost.

Decision: accept if NPV is positive (the project earns more than the cost of capital); reject if negative. Between projects, choose the higher NPV. Examiners report candidates forgetting to deduct the initial cost.

Worked NPV table

A machine costs £250,000. Net cash inflows are shown; year 5 includes a residual value of £20,000. Cost of capital 10%.

Year	Net cash flow £	Discount factor 10%	Present value £
0	(250,000)	1.000	(250,000)
1	70,000	0.909	63,630
2	80,000	0.826	66,080
3	90,000	0.751	67,590
4	60,000	0.683	40,980
5	60,000	0.621	37,260
		NPV	25,540

Strengths and weaknesses

Strengths: uses all cash flows over the project's life; allows for the time value of money; gives a clear money answer linked to shareholder wealth.

Weaknesses: relies on estimates of future cash flows and of the cost of capital; harder to understand than payback; does not show the size of the investment relative to the return (the profitability index helps).

Worked example

A project costs £60,000 and produces net cash inflows of £25,000 a year for 3 years. Using 12% factors of 0.893, 0.797 and 0.712, calculate the NPV.

PVs: 25,000 x 0.893 = 22,325; 25,000 x 0.797 = 19,925; 25,000 x 0.712 = 17,800
Total PV = 60,050
NPV = 60,050 - 60,000

Answer: NPV = £50: positive, so accept

Key idea: NPV = sum of (net cash flow x discount factor) - initial cost; exclude depreciation; include residual value; accept if positive.

Check yourself

A cash inflow of £48,000 is expected in year 3. The 8% discount factor for year 3 is 0.794. Calculate its present value.
Show answer
£38112. 48,000 x 0.794 = £38,112.
A project costs £100,000. Net cash inflows: year 1 £40,000, year 2 £50,000, year 3 £30,000. Factors at 10%: 0.909, 0.826, 0.751. Calculate the NPV.
Show answer
£190. 36,360 + 41,300 + 22,530 - 100,000 = £190.
A project's annual revenue is £180,000, cash running costs are £95,000 and depreciation is £30,000. What annual net cash flow is used in the NPV calculation?
Show answer
£85000. 180,000 - 95,000 = £85,000; depreciation is ignored.
A machine costing £80,000 gives net inflows of £30,000 a year for 3 years, plus a residual value of £8,000 at the end of year 3. Factors at 10%: 0.909, 0.826, 0.751. Calculate the NPV.
Show answer
£588. 27,270 + 24,780 + 28,538 - 80,000 = £588.
Calculate the discount factor for year 2 at 9%, to 3 decimal places.
Show answer
0.842. 1 / 1.09² = 0.8417, so 0.842.
A project has an NPV of -£12,400 at the company's cost of capital. What should the company do on financial grounds?
- Accept it: all projects have some cost
- Reject it: it earns less than the cost of capital
- Accept it if payback is under five years
- Increase the discount rate until NPV is positive
Show answer
Reject it: it earns less than the cost of capital. A negative NPV means the return is below the required rate.
Why is depreciation excluded from NPV calculations?
- It is always too small to matter
- It is included in the discount factor
- It is paid in year 0
- It is not a cash flow; the cash outflow is the initial cost at year 0
Show answer
It is not a cash flow; the cash outflow is the initial cost at year 0. Including both the cost and depreciation would count the outflow twice.

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Last updated 8 November 2026. Spotted a mistake? Tell us.