The Net Present Value Formula attempts to come up with a number that helps answer the question - "which is best?".
When investing you'll almost always have a vast number of options. You can use NPV to help decide which is best. It is particuarly useful deciding between a number of very similiar investments where timing of inflows is the main difference.
NPV derives from the concept of the time value of money. Forget about inflation - it's simple, a dollar now is worth more to you than a dollar in a years time because you can use it now. It is very rare for us to be in a situation where money now is worth less than the same amount of money later.
If you are asked "Do you want a dollar now or a dollar later?" you are probably going to say "now please."
But what say the question is "would you rather have $10,000 now or $12,000 in a years time?" Are you prepared to wait a year to get the extra $2,000? In the current economic climate you probably would, that's 20% extra. But if it was $10,200 in a years time probably not.
Now what say you could have:
- $10,000 now OR
- $10,300 in a years time OR
- $11,000 in two years time?
Which would be better? Or $10,100 in a years time and another $500 the year after that. It gets even harder to decide.
You can use the PV formula to convert each of the figures back to the Present Value to more easily compare and decide which makes best economic sense. The PV formula needs a "discount rate". The "risk free interest rate" is often used, the interest rate at which you can invest your money at no risk. You can use the rate the bank is offering.
So currently you might be able to get 2% interest for a year from bank. So in a year $10,000 would be worth $10,200, and so the Present Value of $10,200 in a year is $10,000.
The Net Present Value formula adds an outflow to the equation. You can use NPV to help decide which is better if you invest $10,000 and -
- you get $200 at the end of the first three years and then $500 at the end of the next two years and $10,000 back at the end of six years, OR
- you get $11,500 back after six years?
Throw the numbers into the NPV formula in an Excel Spreadsheet and it will tell you that the NPV of the first option at 2% discount rate is $371.28 but the NPV of the second option is $1,274.51 so you'd be better of taking $11,500 at the end of six years.
A positive NPV is good, it tells you the money you are gettting in the future makes up for the fact that you don't have it now. A negative NPV is bad, not worth it. An NPV of zero is, "don't really care, why have I wasted my time doing these calculations"
If you want to see the actual NPV formula go here >>> http://www.investopedia.com/terms/n/npv.asp
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