Pre-published version. Not for further distribution
Net Present Value Tool Description
This document explains how to use the Net Present Value Tool. Net Present Value (NPV) is a
financial calculation that determines the risk-adjusted value (called the discounted value) of a
series of cash flows over time. It is a way of determining, in currency, if a New Product
Development (NPD) project can be anticipated to be worth the cost given the risks involved and
make money for the company or organization developing it.
At the core of NPV is the awareness that a dollar tomorrow is not worth the same as a dollar
today if you are not sure you are going to get it. The dollar tomorrow is worth less. Therefore, it
must be discounted when compared to today’s dollar, to reflect that risk. Inflation can cause the
same phenomena of reducing value so it may be added to the discount rate for an NPV
calculation if it is significant. In the NPD process, NPV is used to determine whether the NPD
project is on track to meet its financial targets. NPV can also be used to assess the potential
value of different NPD initiatives as part of portfolio creation and evaluation.
The NPV Tool provides a worksheet to enter estimated cash flows and discount rates for an
NPD project. Embedded formulas in the tool will then generate estimates of future cash flows for
each stage of the NPD project from the Idea stage through Launch, and then into the Post-
launch stage. The tool will provide the calculated NPV at selected intervals over a specified time
period stretching into the future. This tool can be modified as necessary to incorporate factors
that are specific to the NPD project. In addition, the tool can be run repeatedly with different
inputs using different assumptions for each run, to generate multiple cash flow and NPV
scenarios that can then be compared to test the possible outcomes of different decisions.
What is Net Present Value?
Net Present Value (NPV) is equal to the sum of discounted future net cash flows minus any
investment. This document provides a brief introduction to calculating NPV. For those desiring
more information, a review of the Damodaran OnLine website hosted at New York University
1
is
highly recommended, where you will find tutorials on all aspects of valuation as well as a wealth
of data and sources for data to use when making calculations.
NPV is the difference of today’s value of a set of future cash flows minus today’s value of the
cash that must be invested to realize those cash flows. The cash flows used in NPV calculations
come from subtracting revenues from expenses. The discounting used in NPV reflects the
likelihood that those cash flows will not materialize. The discount rate in an NPV calculation is
simply the risk that the cash flow might not materialize.
1
Damodaran Online, available at https://pages.stern.nyu.edu/~adamodar/)
Pre-published version. Not for further distribution
The first part of the formula for NPV of a specific period is the net cash flow for that period,
divided by 1 + the discount rate raised to a power equal to number of periods until the period is
reached for which the net cash flow has been calculated. Each time period must be of the same
duration. Mathematically the formula for a single future cash flow period looks like this:
2
Figure 1: Discounted net cash flow formula for a specific period
The second part of the formula addresses R
0
the current period cash flow. If period 0 has
ended, by definition the investment for the current period is known with certainty and does not
need to be discounted. It is simply subtracted. Similarly, if revenue was booked in the current
period, it also is known with certainty. An example of revenue in an NPD project might be
receipt of a government grant payment supporting your new product research and development
(R&D). Regardless of whether it is negative or positive, the net cash flow for the current period
is added to the sum of the discounted net cash flows.
Because NPV calculation relates to a series of cash flows, the discounted cash flows are
summed.
3
Figure 2: The formula for summing the discounted net cash flows
After summing, subtract the net initial investment (negative cash flow) or revenues (positive
cash flow) in the just-ended current cash flow period.
While the math used to calculate NPV is straightforward, the process for determining the
assumptions to use when estimating cash flows and discount rates is not. The next section of
this document discusses how to make these assumptions.
The discount rate can be calculated in a variety of ways. For many investments, such as a
capital expenditure to build a factory, the firm's weighted average cost of capital (after tax) can
be used. The weighted average cost of capital reflects the cost of capital (the interest rate paid
on a loan) on loans for different kinds of things, such as construction, equipment, operating
2
“Net present value”, Wikipedia, Net present value - Wikipedia, Accessed October 28, 2021. Used in
accordance with the Wikipedia license.
3
Ibid.
Pre-published version. Not for further distribution
capital, and so on. The weighting reflects the proportion of the total sum to be borrowed for that
kind of loan.
However, few projects that involve investments today in the hopes of future revenues are
without other risks or discounting factors attached to them. NPD is an example. That is why the
discount rate is typically calculated from the ground up to account for risk when doing an NPV
calculation for an NPD project. Another reason to do a ground-up calculation of the discount
rate is to consider opportunity cost, inflation, or other factors.
In NPV, risk is systematically evaluated as best as possible – which is a polite way of saying a
guestimate is made – or a rule of thumb is used. Two rules of thumb are common. The first is to
use the discount rate which would be applied to an alternative venture, such as investing the
money in blue chip stocks or buying a government or corporate bond. The problem with this rule
of thumb is that NPD is usually riskier, so using this discount rate as a substitute might be
unrealistic due to the higher risk levels for NPD. Another rule of thumb is to use the firm's
reinvestment rate. The reinvestment rate is the average rate of return for the firm's investments
in other NPD programs in the past, or return on very similar NPD projects. This approach
reflects opportunity cost of investment in NPV, rather than the likely lower cost of capital of the
alternative investments. But as was mentioned before, this rule of thumb suffers from the fact
this is a generalized risk rate and not one specific for this NPD initiative.
Ground-up estimates of the discount rate must include four factors. The first is general macro
level risk that applies to any NPV calculation: anticipated inflation. The last three factors are
intrinsic to the specific NPD initiative. In The Wide Lens
4
, Ron Adner describes three main types
of risk that apply to NPD. Execution risk refers to the ability of your company or organization to
actually conduct NPD. Adoption risk refers to whether the intended customer segments will
actually buy the product or service being developed and the intended end-users actually deploy
it. Co-innovation risk refers to the ability of vendors, suppliers, and partners to provide what you
need as part of your NPD and to conduct their own NPD if that is necessary to develop
consumables or other essential goods needed to effectively deploy your product or service.
These risks need to be calculated and combined. The Gate Progress Review Tool can be used
to support making a ground-up determination of risks that will be used to estimate the discount
rate.
Recall the discount rate is simply the likelihood the anticipated cash flows will not materialize. In
other words, the discount rate is a probability. When adding probabilities, the critical question is
whether they are mutually exclusive or not. If they are mutually exclusive, you can simply add
them. If Adner’s three kinds of risk for the NPD project are mutually exclusive, the discount rate
is 1 minus the sum of the probability of execution risk plus the probability of co-innovation risk
plus the probability of adoption risk. This is expressed mathematically as follows, where D is the
discount rate:
D = 1 - (P
e
+ P
ci
+ P
a
+ I)
P is the probability of occurring and the subscripts represent the first letters of the kind of risk
(P
e
= execution risk probability, P
ci
= co-innovation risk probability, P
a
= adoption risk
probability), and I is the inflation rate.
4
Adner R., The Wide Lens: What Successful Innovators See That Others Miss, Portfolio; Revised edition
(June 25, 2013).
Pre-published version. Not for further distribution
Almost always, Adner’s three risks are interconnected. Therefore, use the formula for summing
the probability of non-mutually exclusive events to calculate the project-specific rate and then
add in inflation as a mutually exclusive probability if you want to include it. The formula for using
the interconnected project specific risks is as follows, where P
NPD
is the probability of NPD
specific risk:
P
NPD
= (P
e
+ P
ci
+ P
a
) – P(P
e
and P
ci
and P
a
)
Next, add the interest rate to calculate the overall Discount Rate:
D = 1 – (P
NPD
+ I)
Because of its utility for doing a check on value for the developing entity, the NPV Tool can and
should be used as part of every gate review in a stage-gate NPD project, as indicated by the
green arrows in the graphic in Figure 3. A calculation of NPV can also be done to measure
value for customers and end-users if desired. In that case you would focus on their relevant
cash flows and risks.
Figure 3: NPV calculations are done at each gate review of an NPD project. At the early gates the NPD is just a quick
estimate. They get more refined as more data is collected as the NPD process progresses. It is especially critical at
the gate between the Design and Development stages due to the rapid rise of expenses that begins there, on the one
hand, and on the other hand, reasonable quality market data should exist for making a projection at this time.
The tool supports all the activities in Module III “Integrating public domain knowledge into
product development processes” of the WIPO publication Using Inventions in the Public
Domain: A Guide for Inventors and Entrepreneurs (2020). In NPD projects using a stage-gate
system, a calculation of NPV is made at every gate as part of the decision to move forward into
the next stage. Over time, the NPV of an NPD project should increase as each stage reduces
the risk of success. If it does not, there is a problem.
How do you enter data in the Net Present Value Tool?
To enter data, you first must estimate cash flows and discount rates.
Cash flow is simply money in and money out (i.e. revenues and expenses) for some specified
period. Cash flow is the lifeblood of a business or any other entity. It represents the money you
have control over to do with as you wish. Negative cash flow means you need financing to
operate. Sufficient positive cash flow means you can self-fund your operations. If cash flow is
v
V
V
Pre-published version. Not for further distribution
high enough, you can even support growth. Thus, one of the key goals of NPD is to generate
free cash flow or positive gross revenues.
Discount rates are the risk that a cash flow estimated to be realized at a specified time in the
future will be worth less than the equivalent cash flow today. The discount rate used for NPD
NPV is like the interest rate used for a bank loan. Both capture an estimate of the reduction of
value of currency over a specified period due to risk.
It is critical to be clear about what you are doing in your calculations of cash flows and choice of
discount rates, so viewers of your NPD financial projections understand how the inputs were
created. You can exclude whatever you want from your calculations as long as you are open
and upfront about doing so. Similarly, for each assumption made, you should document it and
explain why it was done. The NPV Tool workbook provides a tab entitled “Assumptions and
notes” where you can enter assumptions, data used for calculations, data sources, etc., that
were used for the calculations carried out on the main “NPV – single rate” tab in the tool.
Aswath Damodaran, a famous professor of valuation at New York University, once said much of
the tedium in valuation is having to calculate cash flows. This is because calculating future cash
flows is a matter of making and justifying assumptions about revenues and expenses.
There are five steps for estimating cash flow:
1) Estimate the revenues. Revenues can be calculated in two ways. Either you calculate
the units that can be sold and multiply that by the price at which they will be sold, or you
calculate a market size in dollars and estimate what share (percent) of the market you
will capture. These revenues are called gross revenues or gross income, where gross
means before any other costs have been subtracted. Gross revenues are generated
from direct sales of products or services, grants, royalty payments if your company or
organization licenses technology, or dividends and profit sharing if the entity has equity
in another company. Since you are projecting cash flow, a separate calculation must be
made for each year.
For example, suppose you are estimating revenues from sales of a new municipal street
trash bin for cities. You might also look to see if someone has already collected that
data. Most likely, however, you will not find that it is already collected. You might try
counting the number of trash bins in every city of the country where you will sell it. That
would be a very burdensome activity in order to make an estimate. What you could do,
therefore, is get an idea of how many cities of various sizes are in the country. You could
call the city officials responsible for placing and maintaining public street trash bins in
cities of a specific size range and ask them how many are in their city. Then you could
take an average and multiple that by the total number of cities in the appropriate size
group. After doing this for each size group, you could add them up and have a market
size.
When calling those officials, you might also have asked them how often they replace
bins, how they select the ones to buy, and what they pay for trash bins. Let us assume
you have a clear competitive advantage so there is a reasonable basis to assume they
would definitely buy yours when it is available. Then by using the annual replacement
rate you can use the purchase price provided to calculate potential sales per year and
thus annual revenues. If there is not a clear competitive advantage and you do not have
confidence you can capture the total addressable market, you could determine how
Pre-published version. Not for further distribution
many vendors there are, what their market shares are, and make an estimate of what
percent of the total addressable market you can capture each year. A similar approach
might be used if city officials are reluctant to bring in a new vendor even if their product
is clearly superior. Then you need to estimate the ramp-up of sales.
2) The second step is to calculate costs. Costs have two major components: costs of goods
sold (COGS) and operating expenses (OE).
For our purposes here, COGS are the anticipated direct costs associated with producing
and selling the specific product or service being developed, including materials, labor
and factory overhead. COGS includes the costs of the primary activities in Porter’s Value
Chain.
OE are other, more general business expenses such as R&D, general marketing,
administrative costs, etc. which support divergent product lines and families. The nature
of these expenses makes it difficult to allocate them to a specific product line or family
and thus include them in COGS. Instead, a percentage of COGS is commonly used. OE
are the support activities in Porter’s Value Chain. Sometime OE are excluded when
calculating the NPV of an NPD initiative to simplify things. However, when OE are
excluded it is important to make it clear to everyone that these costs are not included in
the calculation, or it would be misleading. Do not fail to include OE if the NPV will be
shown to investors.
Probably the best way to determine costs is to make a ground-up estimate of them. In a
going concern, if the product or service is similar to one already developed and now
being made and sold, an internal estimate will work. If your entity has not done anything
like this before, and if your product or service is like others on the market that are sold by
other companies, then you can look at the annual report of one of those companies or in
some government filing to see if they have included an income statement. From
examining such income statements, you can make an estimate of both COGS and OE
as needed, based on either a percentage of revenues or actual expenditures. A third
way to get cost data is to consult with experts and ask them for their best estimates.
3) The third step is to subtract costs from revenues. This calculation is done in two steps.
First, take gross revenues and subtract COGS to calculate gross profit, which is
sometimes called sales profit. The ratio of net income over gross income is called the
“gross profit margin”.
Second, if OE are included, then subtract OE from gross profit to get net profit or net
loss (which is also called net income). Net means the expenses have been subtracted.
The ratio of net profit over gross revenues is called the “operating profit margin”. It is
generally recommended to include these in your calculation.
4) For investors, or if management desires, a fourth step can be included which involves
subtracting any preferred dividends that will be paid (since these will reduce cash on-
hand) and then adding back any depreciation or other non-cash charges to earnings
after taxes. The result is called “net cash flow”, also called “free cash flow”.
Pre-published version. Not for further distribution
5) After estimating cash flow, a final step that can be added is estimating interest and taxes
and then subtracting these. That leaves net profits. Again, this can be done using a
percentage of COGS.
In NPV, risk is estimated as best as possible – which is a polite way of saying a guestimate is
made – or an NPD-specific rule of thumb is used. Three rules of thumb are commonly used if
the anticipated value of project does not justify a comprehensive ground-up analysis.
The first rule of thumb is to use the discount rate which would be applied to an alternative
venture, such as investing the money in a stock in an equivalent company developing, making,
and/or selling similar goods. The problem with this rule of thumb is uncertainty about whether
your NPD is riskier or less risky, so it can be a crude substitute.
A second rule of thumb is to use the firm's reinvestment rate. The reinvestment rate is the
average rate of return for the firm's investments in other NPD programs in the past, or return on
very similar NPD projects. This approach reflects the opportunity cost of investment in NPV,
rather than the likely lower cost of capital of the alternative investments. But as mentioned
before, this rule of thumb suffers from the fact this is a generalized risk rate and not one that is
specific for this NPD initiative. Further it assumes the entity has a track record based on
previous NPD projects.
The third rule of thumb for calculating a discount rate is to use a rate a venture capitalist might
rely on when making an investment in a company, based on your Business Model Canvas and
staff and company or organization’s experience. These rates are adjusted up or down each
period in light of the technology readiness level (TRL) of the product or service for the
appropriate stage of NPD. This is our preferred rule of thumb if the NPD project does not justify
the time and expense of making a ground-up estimate. Figure 4 is an example of such discount
rates and the rationales for selecting each rate. It was developed using data in Richard
Razgaitis’ book Early-Stage Technology: Valuation and Pricing.
5
As this book was published in
1999, it makes sense to confirm the rates you choose to use by interviewing some venture
capital firms in your country and doing web research.
5
Richard Razgaitis, Early-Stage Technology: Valuation and Pricing (Wiley, 1999).
Pre-published version. Not for further distribution
Figure 4: Discount rates from venture capital. Figure courtesy of Foresight Science & Technology.
If inflation is a significant factor, you can usually find inflation figures from a government or
financial sector website. This information is then added into the results.
If you are using ground-up estimates instead of using a rule of thumb for the discount rate, then
the ground-up estimates of the discount rate must include four factors. The first is anticipated
inflation, which is simple and considered a macro level risk. The last three are intrinsic to the
specific NPD initiative. They are execution, co-innovation, and adoption risks. These need to be
calculated and combined as discussed above. The Gate Progress Review Tool can be used to
support a ground-up determination of the discount rate.
Now turn to the NPV Tool spreadsheet itself and start entering cash flows and discount rates.
Before doing that, remember that unlike the other tools in this NPD Toolkit, the spreadsheet in
the NPV Tool almost always needs to be modified to fit the specifics of your project. A
discussion of how to modify the Tool is provided later in this description. Another option is to use
one of the many NPV tools you can find through web searching, should that fit your needs
better. Yet another option, if you are familiar with Microsoft Excel, is to build a new spreadsheet
and use the NPV and Internal Rate of Return (IRR) formulas built into Excel to calculate those
values. As always, remember that whatever spreadsheet or calculator you use, it is critical to
document your assumptions at every step. As noted previously, the NPV Tool workbook
provides a tab entitled “Assumptions and notes”, where you can enter the assumptions, data
used for calculations, data sources, etc., that you used for the calculations carried out on the
“NPV – single rate” tab. Otherwise, a viewer cannot understand why those numbers have been
entered into the spreadsheet, and why you obtained the results shown on the spreadsheet.
Pre-published version. Not for further distribution
How do you interpret the data in the Net Present Value Tool and
use it in your NPD process?
The first task before interpreting any data in any NPV calculation is to determine whether the
assumptions behind it seem reasonable. The second task is making sure you do not have a
spreadsheet error. Click on Formulas, then Trace Precedents to check the assumptions that
went into the formulas you used, and to check for potential error in the formulas themselves.
Only then can you interpret the results and use them in a stage-gate review.
The assumptions behind the data for the Biofuels Example using this tool should be considered.
There is a very high discount rate for the Idea stage. All things being equal, this would normally
be a showstopper. In this case, however, assume the cost for the Idea stage is low enough that
management decided to continue because of a commitment to building a greener economy and
greater energy independence for their country.
In this spreadsheet, there is no further calculation of discount rate after the Post-launch stage
until near the end of the 10 years over which the spreadsheet runs. The assumption behind this
is that for periods 17 through 19, hitting market saturation during this time was anticipated, after
which sales become harder to find. Assume it will be necessary to introduce an improved unit
before then, as per the NPD portfolio, so any sales of the older model would only involve using
up remaining previously purchased parts inventory.
Interpreting the results is a matter of seeing if the NPV you calculate is acceptable. At a gate
review, the next step is to estimate what the discount rate is anticipated to be at the end of the
next stages. If those are also acceptable, that is probably a good sign that you can safely
proceed. If both the current and future NPVs look good or are otherwise acceptable, you would
probably decide to go forward into the next stage. If the NPV for the current period or future
ones looks bad, figure out why and see if risk mitigation can reduce the discount rate by
reducing the risk-associated factors that go into estimating the discount rate. The Life Cycle
Risk Reduction Tool is helpful for exploring ways to modify the Action Plan in order to reduce
risk. The Gate Progress Review Tool is useful for assessing the impact on the discount rate of
any changes in the Action Plan.
When the results in the Biofuels Example spreadsheet for this tool are interpreted, it seems that
a Go decision at some of the early gates, such as the decision to move from the Idea stage to
the Screening stage, is a reasonable high risk, high reward decision. Management has
accepted the high risk for the early stages so long as the rewards look excellent. The
calculations of high gross profit and internal rate of return support an expectation of high reward.
Of course, the decision to move forward at any gate would depend on whether the cost for the
next stage was low enough that management could afford, and was willing, to continue
investing even if the project was terminated at the end of that next stage. Assuming the NPD
team can demonstrate a strong anticipated competitive advantage, that would help the project
make it through this next gate because the anticipated advantage supports the expectation of
attaining high returns. A good likelihood of winning a government grant to fund R&D would also
support a Go decision. If the cost of development is zero and the market prognosis is good, that
would provide a strong reason to continue.
Pre-published version. Not for further distribution
When using the Tool for your own NPD project, be aware that you can run various scenarios
based on various sets of assumptions. It is recommended to run at least three scenarios
including a most likely scenario, a best-case scenario, and a worst-case scenario.
The point of this exercise is to explain and illustrate that the numbers entered into the NPV Tool
spreadsheet have to make sense in light of what is happening in the entity carrying out NPD, in
the market, and in the larger environment. If you write down and explain your assumptions, then
a viewer can either agree or disagree with them. If they disagree with your assumptions, they
can ask you to use different numbers and run that scenario.