Reader question: calculating a basic NPV problem
Corporate finance, MBA topics
My philosophy on maintaining this blog site is very different from that of most bloggers. Rather than update it constantly with the latest happenings, I aim to write longer how-to explanations and tutorials that are less time-sensitive and provide useful reference material long after they’re written.
Though my posting rate has declined dramatically recently (this will improve soon), I still receive questions from readers, mainly about using Excel functions. Last week, I received one from a reader named Jae, who asked a Finance 101 question:
I have a problem in my finance class where the annual revenues from a project is $500,000 and annual costs are $300,000. The corporate tax rate is 40% and the cost of capital is 12%. How do I calculate NPV of the project?
The original problem has probably been paraphrased, and lacking other information, here’s how I’d interpret the problem. The project generates pre-tax revenues of $500K a year, and incurs operating costs of $300K a year. The corporate tax rate is 40%, the cost of capital is 12%, but nothing is provided about how long the project will last. For simplicity’s sake, let’s suppose it lasts 5 years and then ends at the end of year 5.
The setup for solving this problem is very similar to another post I wrote on how to calculate net present value (NPV) a while back.
Here’s how I’d set up the calculation in Excel to solve this problem, assuming the project lasted 5 years:
