The Portable MBA in Finance and Accounting, 3rd Edition

Planning Capital Expenditure 301

was forecast to generate $2.42 million of cash in year 1. The present value of
that cash f low, as of year 0, is $2,016,670, computed as follows:

Similarly, the year-2 cash f low was forecast to be $2.42 million also. The pres-
ent value of that second-year cash f low is only $1,680,560:

The longer the time over which a cash f low is discounted, the lower is its pres-
ent value. Exhibit 10.4 presents the forecasted cash f lows and their discounted
present values for the brewery project.

Summing the Discounted Cash Flows
to Arrive at NPV

Finally, we can calculate the NPV. The NPV is the sum of all discounted cash
f lows, which in the brewery example equals $614,000. To understand precisely
what this means, observe that the sum of the discounted cash f lows from years
1 through 10 is $10,614,000. This means that the project generates future cash
f lows that are worth $10,614,000 today. The initial cost of the project is
$10,000,000 today. Thus, the project is worth $10,614,000 but costs only
$10,000,000 and therefore creates $614,000 of new wealth. The managers of
the beer company would be well advised to adopt this project, because it has a
positive NPV and therefore creates wealth.

PV=

()

=

$, ,

.

$, ,

2 420 000

120

2 1 680 560

PV=

()

$, , =

.

2 420 000 $, ,

120

1 2 016 670

EXHIBIT 10.4 Discounted cash f lows for

brewery project (thousands).

Year Cash Flow Discounted Cash Flow

0 $(10,000) $(10,000)

1 2,420 2,017

2 2,420 1,681

3 2,420 1,400

4 2,420 1,167

5 2,420 973

6 2,420 810

7 2,420 675

8 2,420 563

9 2,420 469

10 5,320 859