Definition and Examples of Net Present Value (NPV)
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’s generally better to have money now than to receive the same amount of money in the future. With NPV, you can decide if an investment or a project makes sense.
For example, assume you win $1 million from the lottery but you choose to receive payments of $100,000 per year for the next 10 years. While that adds up to $1 million, what is your prize really worth in today’s dollars? If there’s an option for a lump sum payout, what amount is equivalent to that series of payments?
NPV can help you figure this out. The value of your payments depends on what you do with the money and how much you might earn if you invest the funds. If you assume that you can safely earn 3% on your money, the NPV of the payments is $853,020.28. Put another way, if you can get more than $853,020.28 today, it may be worth taking the lump sum instead of the annual payments.
Other factors besides NPV may also be important. For example, if you can’t be confident that you’ll get all of the cash flows you assume in the NPV calculation, it may make sense to pass on some opportunities.
How Net Present Value Works
NPV calculates the present value of each cash flow (converting future cash flows to today’s dollars) and adds them up—including both income and outflows. With that information, you know how much a series of payments is worth, and you can compare that value to other options available to you today.
For example, NPV can be useful when deciding if it makes sense to purchase a new piece of equipment for your business (an additional delivery vehicle, for example). If the NPV of future revenues exceeds the cost to pay for the equipment, it may be a good strategy. Likewise, in the oversimplified lottery example above, you can use NPV to help you decide if you want to take a lump sum or a series of payments.
How Do You Calculate Net Present Value?
To calculate net present value, add up the present value of all future cash flows. It’s easiest to calculate NPV with a spreadsheet or calculator. The process gets cumbersome if you have numerous cash flows.
NPV = Cash Flown / (1 + Discount Rate)n
Note that “n” is the periodic cash flow. For example, if you’re receiving annual income, n=1 represents the first year, n=2 represents the second year, and so on.
How to Calculate Net Present Value in Excel and Sheets
Popular spreadsheet offerings like Excel and Google Sheets can calculate NPV easily. Use the NPV function for quick answers.
For example, assume your discount rate is 4%, and cash flows are $10,000 for the next four years. Enter the following in Excel or Sheets: =NPV(0.04, 10000,10000,10000,10000)
Your result should be $36,298.95.
Limitations of Net Present Value
Predicting the Future
NPV relies on assumptions about the future, such as how much you can earn on your money. Everything gets boiled down to a single number, but that number might summarize many years’ worth of cash flows in a complicated world. Changing the rate slightly can alter the results dramatically, so it’s crucial to acknowledge that your assumptions might be off.
Your assumptions might not capture all of the unintended consequences or second-order effects of a decision. For example, when deciding whether or not to take a lump-sum payment or a series of income payments, various outcomes can unfold after you make your decision. What if tax rates change in the future? What if you get sued shortly after taking the lump sum?
Business decisions can get similarly complicated. When deciding whether or not to purchase a second delivery vehicle, you might not account for everything that accompanies that decision. Will your production crew be able to accommodate increased demand? Will competitors step into the market if they notice your expansion (and how will that affect pricing and future cash flows)?
- NPV provides a value in today’s dollars for a series of future cash flows.
- With NPV, you can decide if an investment or a course of action makes sense.
- Spreadsheets like Excel and Sheets make it easy to calculate NPV.
- The assumptions that go into your calculation may be oversimplified.
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