or would be (1+i)1, the second year's accumulation factor would be (1+i)2, and so on through the five years. By dividing the projected cash flows by the accumulation factor, the present value of the cash flow is calculated. When the five present values are added together, the total present value of the cash flow is generated. By subtracting the original investment from the total present value, the net present value is learned. So long as the net present value is a positive number, the investment can be viewed as viable.
Company A might be considering taking out a $200,000 loan, payable over five years, to purchase new equipment. The company expects that the equipment will increase the company's cash flow by $40,000 the first year, $45,000 the second year, and $50,000 in each successive year. For purposes of these calculations, the loan will be paid in five annual installments with a ten percent interest rate. If we simply sum the cash flow and compare that to the loan amount, we find that the cash flows exceed the loan amount by $35,000. However, that ignores the effect of the interest rate. Using the net present value theory, we can generate the following table which illustrates that the loan is not as good an investment as it first appears. Instead, the company should seek lower cost equipment, or equipment which offers greater cash flow.
Just as lenders have different options they can exercise with regard to how they invest available funds, so borrowers often have different investment options to choose from. A company considering expansion, for example, may have to decide between purchasing several different types of capital equipment to accomplish a task. Some machines have high initial costs, but may require fewer workers to maintain. Other machines may increase productivity and enable the company to manufacture more units in a shorter period of time. Each of these factors must be taken into account when calcula...