The Net Present Value, or NPV, is a vital element in finance. If you think about it in comparison with other concepts, NPV is not that difficult to grasp. Yet many people have a hard time in figuring out what it means and how to deal with it. Therefore, what is the Net Present Value and how to use it in finance? Here is a small guide on the concept and how to calculate it.
What is the Net Present Value?
NPV can be easily defined as the present value of a series of cash inflows and outflows over a period of time. In other words, the Net Present Value looks at the profitability of an investment. Once businesspeople make an investment, they can use this formula to see if it achieves their initial desired target.
In case you cannot reach this target, NPV shows you how to solve the problem. By using the formula, you can discover how to tackle the investment and what to add to it to get to the target. However, in this case, you make an assumption that everything else stays the same.
How to calculate the Net Present Value?
There is a formula you can use to calculate the Net Present Value. Basically, it is the sum of each cash flows C for an individual period n throughout a general bigger period N, that you have to discount at the rate of return of the investor r. More precisely, the formula looks like this:
Cn is the cash flow during the period n. N represents the number of all time period taken into consideration, and r is the rate of return.
This might look a little intimidating, but the matter is actually not complicated at all. If the result of the formula is a positive Net Present Value, it means the investment has reached the expectations of the investor. Therefore, this illustrates a profitable investment. A negative Net Present Value is one that is not profitable and results in losses for the investor.
How to understand the Net Present Value?
According to the formula, NPV is a way to discount some future cash flows to the current time according to a certain discount rate. To put it more simply, the net present value represents value minus cost. You can use this formula to find out if the goods and services you are value are worth more than you pay for them.
Given the fact that money is involved, simply assessing its value is a tricky thing to do. Usually, money is worth more in the present than it is in the future, as a result of the time value of money. This might make any kind of investment unprofitable. However, there’s a way to solve this problem.
The solution is given by the rate of return in the formula. This discount rate will account for the possible risks you might experience when making the investment, as it calculates the amount of money the investment might bring back.
Categories of Net Present Value
As mentioned above, you can get different results when calculating the Net Present Value. There are three situations that are possible. The Net Present Value can be positive, it can be equal to zero, or it can be negative.
In case of a positive NPV, the value of cash inflows is bigger than the cash outflows. This means you get more money than you invest, so the investment is profitable. If you have a zero NPV, it means the values of cash inflow and outflow are equal. You make no profit, but the investment is still an acceptable one. The only one that is not acceptable is the one producing a negative NPV. In this case, the investment produces more losses than earnings.
Disadvantages of Net Present Value calculations
People use the Net Present Value to see if their investments will turn out profitable. However, using only these calculations can be tricky. First of all, NPV is based mostly on assumptions than on real facts. Sometimes, a situation might require a series of unexpected expenses or extra funds which are not accounted for by this formula. Therefore, you can easily go wrong with your assessment.
Also, the discount rates might not always be perfectly accurate. They might disregard certain risks, assuming the highest cash inflow there is when, in reality, the situation is different. Therefore, you won’t get to account for any unexpected situations or sudden losses, and what NPV will reflect won’t be the real situation.
An alternative to the Net Present Value
Therefore, it has appeared an alternative method that is a little more accurate. This method is called the payback period. This is a little easier, and consists of calculating the time needed by an investment to produce the money needed when everything started. However, this method isn’t foolproof either. The payback period doesn’t take into account the time value of money.
Before choosing a method to evaluate your investment, you first need to do an assessment of how it will look like. If it should last for a longer period of time, there are greater chances that the payback period won’t be effective. This happens because there are too many factors that will influence the value of money over that long period of time.
Also, the payback method has one more limitation. It accurately accounts for the time you get back the initial investment. However, once you have earned the money you invested, it is no longer useful. This means you cannot predict if the investment stays profitable after that.
The Net Present Value is a good way to assess your investments and see if they were worth the effort. This might not be the most foolproof method there is, but it’s a good way to have a better idea about your investment. After you perform the calculations, you can find out if your investment is profitable and if the value of the money you invested will stay the same after a certain period.
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