What is net present value?

Introduction to the article:

What is Net Present Value

Net Present Value (NPV) is the present value of a series of cash flows condensed into a single figure. NPV calculates the value of discounted cash flows in “today’s dollars.” Discounting refers to the time value of money and the fact that it is generally better to have money now rather than receiving the same amount of money in the future. Using NPV, you can determine whether an investment or project is worthwhile.

How does Net Present Value work?

Net Present Value calculates the present value of each cash flow (by converting future cash flows into “today’s dollars”) and sums them together – including income and expenses. With this information, you know the value of a series of cash flows and can compare that value to other options available to you today.

How to calculate Net Present Value?

To calculate Net Present Value, sum the present value of all future cash flows. It is easier to calculate NPV using a spreadsheet or calculator. The process can become tedious if you have many cash flows. NPV = Cash Flows / (1 + Discount Rate) ^ n. Note that “n” is the periodic cash flow. For example, if you are receiving annual income, n = 1 represents the first year, and n = 2 represents the second year, and so on.

Limitations of Net Present Value

Net Present Value relies on assumptions about the future, such as how much you can earn on it. Everything is condensed into a single number, but that number may summarize several years of cash flows in a complex world. A slight change in the rate can lead to radically different results, so it is important to acknowledge that your assumptions may be inaccurate.

Summary:

Net Present Value provides a value in “today’s dollars” for a series of future cash flows. Using Net Present Value, you can determine whether an investment or project is worthwhile. Spreadsheets like Excel and Google Sheets make it easy to calculate Net Present Value. The assumptions you put into your calculation can be overly simplistic.

Source: https://www.thebalancemoney.com/what-is-net-present-value-5194604