Net present value (NPV) is a concept that allows you to calculate the value of future cash flows at the present time. Finding this value is pretty straight forward using the Net Present Value formula. It’s possible to figure out Net Present Value using Excel, but there are also online calculators that make it even easier to find. Sound confusing? Don’t worry, we’ll help explain.
The Time Value of Money
Net present value is based on what’s known as the time value of money. The time value of money is a concept that states that money today is worth more than money tomorrow (or any future time period). This is because you could use that money to invest in financial instruments like equities in the stock market to earn more than what you started with.
For instance, would you rather want $100,000 today or $100,000 fifty years from now? In all likelihood, you would take the money today because you could use the cash to start a business or invest and grow your initial $100,000 into much more. Of course, there is also a chance that you could lose everything, but the time value of money focuses on the positive potential.
Net Present Value
Net present value takes the concept of the time value of money one step further. The net present value is the sum of present values of money in different future points in time. Calculating your NPV is a helpful method of comparing projects or investments that produce different cash flows over time.
The Interest Rate
One key additional component of NPV is the interest rate (also called the discount rate) used to discount the future value of cash into present value. This interest rate in essence is the estimated return you would receive each year if you invested your money and therefore, what you would lose if you did not invest your money.
This interest rate depends on the riskiness of your investment. Generally speaking, the higher the risk, the higher the interest rate because there is less certainty about your future potential earnings. An increase in your interest rate results in a lower NPV, while a lower interest rate results in a higher NPV.
Net Present Value Formula
PV = present value
FV = future value
i = interest rate or discount rate for a specific period
n = the number of periods between present and future
Net Present Value Example
For example, let’s say that you had two potential investment options. Option A allows you to invest in a shoe manufacturing company that would generate $5,000 annually over the next 5 years. Option B allows you to invest in a grocery store that would generate $3,000 for the first 3 years and then $8,000 for the last 2 years. If you do the math, both eventually generate $25,000 over 5 years.
However, based on the net present value of these two investment options, one option is financially more attractive than the other. Assuming both opportunities are equally risky and have a discount rate of 10%, here are how the numbers shake out:
As you can see, even though both investment options generate $25,000 over 5 years, Option A results in a higher NPV. In this example, this is largely due to the fact that you earn higher amounts of cash earlier. Due to the exponential factor in the denominator of the NPV formula, receiving more cash later vastly reduces distant future cash flows.
Net Present Value in the Case Interview
The NPV concept may be helpful in case interviews where you have two potential options that you would like to compare in terms of financial attractiveness. This is highly possible given that problems in case interviews usually involve businesses dealing with the unknown. Many businesses use NPV calculations to weigh multiple possible options as they are making business decisions. Be on the lookout for this scenario in the case interview and earn bonus points by suggesting the use of the NPV formula to find the best solution for your client!
Net Present Value Calculator
There are multiple Net Present Value calculators free to use on the web. Using an online calculator is an good way to determine Net Present Value. Net Present Value calculators online are easy to use and most of the time free. Here are a couple of our favorites: