What is NPV?
The term NPV stands for Net Present Value, which is a Discounted Cash Flow (DCF) method used in forecasting the long run desirability of an investment (capital outlay).
Specifically, net present value discounts all expected future cash flows to the present by an expected or minimum rate of return. This expected rate of return is known as the Discount Rate, or Cost of Capital.
If the net present value of a prospective investment is a positive number, the investment is deemed to be desirable. On the other hand, if the net present value turns out to be a negative number, then the investment is deemed to be undesirable.
Furthermore, net present value analysis can also be used to determine which of two or more alternative desirable investments is the most desirable.
What is a Discounting?
Think of discounting as the opposite of compounding. In compounding, you take a present amount (principal) and compound the interest earnings into the future. Whereas discounting takes a future value and discounts it back to the present (principal).
To illustrate the difference between compounding and discounting, if you were to invest $100 today in an investment that paid a 10% annual return, and you wanted to know how much your investment would be worth 1 year from now, you would compound the interest by multiplying the principal by 1 plus the rate (100 x 1.10 = $110).
Conversely, if you wanted to know how much you would need to deposit today for your investment to grow to $110 in 1 year, you would discount the future value by dividing it by 1 plus the rate (110 ÷ 1.10 = $100).
What is the Discounted Cash Flow (DCF) Method?
In the case of net present value analysis, the DCF method takes each future cash flow and reduces the amount by how much of that cash flow represents interest earned if its principal portion were invested at the time investment originated.
Then, once all future cash flows have been discounted, to arrive at the net present value, you then sum all discounted cash flows and subtract that amount from the original amount invested.
How is the Discount Rate Determined?
Typically, when deciding what rate to use when discounting cash flows, the rate used is equal to the highest rate you know you could earn elsewhere.
For example, if you know of two other alternative investments (A & B) and if you know with a fair amount of certainty that you could earn 6% in alternative A and alternative B would earn 5%, then use alternative A as the rate for discounting cash flows.
Why is NPV Important?
To demonstrate the importance of net present value analysis, suppose I ask you for $1,000 today, and in exchange, I promise to pay you $200 per year for five years, and then give you an extra $100 in year six, as shown in the following cash flow chart:
| Year | You Give Me (Outflows) | I Pay You (Inflows) |
|---|---|---|
| Now | $1,000 | |
| 1 | $200 | |
| 2 | $200 | |
| 3 | $200 | |
| 4 | $200 | |
| 5 | $200 | |
| 6 | $100 | |
| Totals | $1,000 | $1,100 |
Now, if you were unaware of the effects of the time value of money on my proposal, you might say, "Wow! I could earn $100 without doing anything? Here's the $1,000!" But this is where the importance of NPV comes to light.
So is my hypothetical offer something you should consider accepting? Well, that depends on what annual rate of return you could earn if you chose to turn down my offer and invest the $1,000 somewhere else.
For example, using the net present value calculator, you will see that if you know you could earn a 5% annual return (entered as the discount rate) somewhere else, then taking me up on my offer will end up costing you $59.46 in interest earnings (the opportunity cost of giving me $1,000 today in exchange for my $1,100 in future payments, versus investing in a project offering a higher rate of return).
| Schedule of Cash Flows Discounted at 5% | ||||
|---|---|---|---|---|
| Year | Outflows | Inflows | Net Cash Flow | Dis- counted Cash Flow |
| 0 | $1,000 | -$1,000 | -$1,000 | |
| 1 | $200 | $200 | $190.48 | |
| 2 | $200 | $200 | $181.41 | |
| 3 | $200 | $200 | $172.77 | |
| 4 | $200 | $200 | $164.54 | |
| 5 | $200 | $200 | $156.71 | |
| 6 | $100 | $100 | $74.62 | |
| Totals: | $1,000 | $1,100 | $100 | -$59.48 |
On the other hand, if you knew the most you could earn on any other alternative investment was a 2% annual return, then accepting my offer would result in a gain of $31.49 over what you could have earned.
| Schedule of Cash Flows Discounted at 2% | ||||
|---|---|---|---|---|
| Year | Outflows | Inflows | Net Cash Flow | Dis- counted Cash Flow |
| 0 | $1,000 | -$1,000 | -$1,000 | |
| 1 | $200 | $200 | $196.08 | |
| 2 | $200 | $200 | $192.23 | |
| 3 | $200 | $200 | $188.46 | |
| 4 | $200 | $200 | $184.77 | |
| 5 | $200 | $200 | $181.15 | |
| 6 | $100 | $100 | $88.80 | |
| Totals: | $1,000 | $1,100 | $100 | $31.49 |
By the way, if you wanted to find out the average rate of return of my hypothetical offer, you could use the IRR Calculator -- which uses a variation of the Discounted Cash Flow method for determining the internal rate of return from a series of cash flows. Plugging the above cash flows into the IRR Calculator will reveal that my offer would yield a 2.99% average annual rate of return.