Calculate Net Present Value
Net Present Value (NPV) measures the viability of a project or investment by taking into account the investments (outflow) and returns generated (inflow) from the investments. It is computed based on the sum of a series of cash flows in and out. NPV takes into account the series of cash paid or received in today’s value. This is different from a layman calculation of cash flows which only takes into account the dollar value of the cash flows. For example, we take out $1000 from our pockets to invest in a business venture. In one year’s time, the business venture pays out $1,100 and we put this money into our pocket.
To a layman, the net investment gain is $100 ($1,100 – $1,000). Using NPV, the amount is smaller. This is because we take into account what our initial $1,000 would have earned us if we put it in the bank. Assuming that the interest rate is 5%, our $1,000 would have earned us $1,050. Therefore the net investment gained would have been $50 ($1,100 – $1,050). That’s not all. The amount of $50 is what we would have gained in one year’s time. But in today’s time, that $50 would have worth less today. That means if we put less than $50 into the bank, we would have gotten that $50 in one year’s time. The exact amount is $47.62($50 / 105%). This amount is the Net Present Value of our cash out flow of $1,000 (denoted by a negative sign) plus a cash inflow of $1,100 in one year’s time (denoted by a positive sign).
Sounds complicated? Here’s another way of looking at it. That $1,100 in one year would have a present value of $1,047.62 ($1,100 / 105%). Since we took out $1,000 to gain that $1,100 (which has a present value of $1,047.62), the NPV is $47.62.
After you have understood the concept, you would not have to subject yourself to this kind of calculation. You can use a time line to present the above concept and an Excel Formula to calculate the Net Present Value.
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