What is Net Present Value: Concept, Usage & Examples

Do you sometimes wonder why money in hand now is more valuable than the money you will have in future? It is because, with the money you have at this moment, you can multiply it by investing in something or selling an asset. 

The money you will have in future is firstly uncertain, as it can be affected by inflation that decreases its buying power. So, if you want to compare the value of money you have now with the money you will acquire in the future, you need to know what net present value is (NPV). 

Keep reading to know more!

Net present value (NPV) is the overall value of all the future cash flows, whether positive or negative. It is a method to calculate your return on investment (ROI) for an expenditure. This is a financial modelling method that accountants use for capital budgeting. 

In other words, this is the difference between the present value of cash inflows and cash outflows over a fixed period. Analysts and investors also use NPV to evaluate the probable profit limits of their proposed projects.

Positive net present value occurs when the projected earnings that any investment or project generates exceed the expected costs. The opposite of this is the negative NPV.

Since the latter can result in a net loss, it is always wiser to invest with a positive NPV. This is because it will be profitable.

To calculate multiple periods of projected cash flows, one can use this net present value formula to find the present value of each time.

                 Cash Flow

NPV = Σ

               (1+i)

“i” represents the discount rates or required returns 

“t” represents the number of time periods

To understand the functioning of NPV, we can compare two projects to invest in and keep its discount rate at 10%.

Net present value analysis is used to calculate the worth of any investment, project or cash flow series. This is an all-encompassing metric as it considers all expenses, revenues and capital costs that are linked with an investment in its Free Cash Flow. 

Along with considering all kinds of costs and revenues, it also checks the timing of each cash flow. Thus, creating an impact on the present value of an investment.

Here are the following reasons why cash flows are discounted:

• Adjusting to the Risk Factors of an Investment 

As the risks of businesses, projects or other investment opportunities vary from one another. Therefore to counter the risks, the discounted rate is higher for investments that are more prone to risks. In contrast, the rate is lower for those investments which are much safer.

• Incorporating the Time Value for Money

It is essential to include the TVM because the value for money is more as soon as one receives it. Otherwise, there are many factors that affect the value of money like inflation, interest rates, and other opportunity costs.

Since the net present value is the core element of budgeting in a company, no one usually calculates it manually. However, in Excel, there is a function to find this value. You just need to enter the stream of costs and benefits.

In Excel, you get two functions to calculate the Net Present Value: NPV and XNPV. Both functions use the same formula; only the difference between these two is:

NPV assumes all cash flows in a series occur at regular intervals, like monthly, yearly, quarterly, etc.

XNPV allows cash flow to occur on specific dates. Hence the series can be at irregular intervals.

As you have read so far, you know what net present value is (NPV). Practically, it is just a method to calculate your ROI. It is mostly used to compare projects and choose which one is more profitable. However, scholars suggest that using NPV as a tool is up to an analyst, as there are certain drawbacks.