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.
Do you know that share prices can be determined using NPV? Would you like to own such a template that will show you how this is done? If you do, fill up the form below and I will send you the template via email.a
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