Any business planning implies accepting business risks. These risks predominantly derive from the inability to predict the economy and the behavior of people or markets. The economists deal with the calculation of possible losses for a given period when it comes to measuring risks.
Determining the net present value: the calculation of risks
That’s why a need to quantify the risks emerges. In this case, analysts will know in advance, long before the investment is made, which investments can generate additional funds in the future and which can’t.
A set of indicators is used to choose a particular investment project. The most widespread are the methods allowing assess the impact of time on the funds (usually, it is the depreciation of funds). However, this effect can be revealed in a variety of ways in different economies.
How to calculate net present value in a business plan
One of the most commonly used indicators to assess an investment project is the net present value that is calculated according to the following formula:
ICF – input cash flows during a certain period;
OSF – output cash flows covered during a certain period;
I – volume of investments made for a certain period. At the same time, the real cash flow is used for the calculations and not the figures of financial performance.
t – number of periods for which the cash flows are investigated;
r – discount rate.
Let’s consider the calculation of the net present value in an Excel sample of a business plan.
Calculation of the net present value allows evaluate an investment project by means of discounting. Discounting is the conversion of future money into its present value. The rate used as a coefficient of money value reduction is chosen depending on the economy development, the investment climate and the availability of credits.
The project should be considered when the NPV indicator is positive.
Approaches to the analysis of the net present value in business planning are as follows:
1) Cash flows are re-calculated taking into account the risk factor (discount rate);
2) Cash flows are discounted considering the risk and then without it.
The first approach is used when it is necessary to adjust the risk premium according to the interest rate. That is, if the discount rate is high, then a risk rate should be high too.
Disadvantages of NPV
NPV has the disadvantages as follows:
1) risk measurement is carried out by re-calculating the risk premium. The risk is measured in terms of uncertainty or impossibility of forecasting. So, the risk premium does not take into account many factors that may affect its size. Paying the investor’s interest, the business owner does not foresee a number of other factors.
2) The second weakness is connected with the fact that when an enterprise goes through the initial stage of its development (1-2 years), the risks change completely, which is not taken into account in the determination of the risk premiums.
Calculation of the NPV with and without the risk rate is more practical. The future value of money is influenced by many factors that can be predicted if a country supports a stable economic environment. This provides an opportunity to assess the impact of the very risk on the future cash flows of the company.
Get templates from:
- Example of Business Plan in Excel
- Excel template of a business plan for the UK
- Business plan in Excel for startup
- Excel model of a business plan
- Download a business plan into Excel and get a ready model of calculations