What is Net Present Value?

Calculating the Net Present Value (NPV) of cash flows for an investment is important because of the time value of money, which suggests that a dollar today is generally worth more than a dollar in the future. There are several reasons for this!

• People generally have a preference for having and enjoying money now
• We don’t know if we’ll be around to enjoy future cash flows
• There’s expected inflation, which means we might expect a dollar to buy less stuff in the future than it can today

Put another way, and this is probably reflected in all 3 of the reasons, if you had the money now, you could invest it and have the money plus a certain amount of interest in the future!

When it comes to actually calculating the net present value of something like an investment, it’s crucial to determine the appropriate discount rate. The higher the discount rate is, the more future cash flows will be discounted when calculating their present value. Hence, the discount rate used can have a big impact on whether the investment is expected to be a good one or not. Here are some factors that can influence the discount rate:

• The higher the expectation of future inflation is, the higher the discount rate will be.
• Especially if a company or person would be borrowing to make an investment, the rate at which they could borrow based on their risk level would influence their discount rate. The perceived risk level associated with the investment from the individual or company’s perspective could also add to that discount rate. If the payoff of the investment is relatively certain, the discount rate would be lower than if there was a lot of uncertainly around the future expected cash flows.
• If a company or person would be using their own money to make the investment, the discount rate would be highly influenced by the rate of return they could get on other investments of a similar risk level.

The discount rate essentially represents the opportunity cost of money at a certain risk level. Watch the video above for some real net present value use cases calculated in Excel.

You can download the Excel worksheet used in the video above here.