Net Present Value (NPV). Net present value calculation

Investments will be justified only when they contribute to the creation of new value for the owner of capital. In this case, the cost of these values is determined, which exceeds the cost of their acquisition. Of course, the question arises as to whether it is possible to assess them more than their real value. This is available if the final result is more valuable in comparison with the total cost of the individual stages, the implementation of which made it possible to achieve this result. To understand this, you need to know what the net present value is and how it is calculated.

What is present value?

Present or present value is calculated based on the concept of money over time. It is an indicator of the potential of funds allocated to generate income. It allows you to understand how much the amount that is currently available will cost in the future. Carrying out an appropriate calculation is of great importance, since payments that are made in a different period can be compared only after they have been brought to the same time interval.

The present value is formed as a result of bringing to the initial period of future receipts and expenditures of funds. It depends on how the interest is calculated. For this, simple or compound interest, as well as annuity, are used.

What is Net Present Value?

Net present value NPV is the difference between the market price of a particular project and the cost of its implementation. The abbreviation that is used to designate it stands for Net Present Value.

Thus, the concept can also be defined as a measure of the added value of the project, which will be obtained as a result of its financing at the initial stage. The main challenge is to implement projects that have a positive net present value. However, first you need to learn how to define it, which will help you make the most profitable investments.

Basic rule of NPV

You should familiarize yourself with the basic rule that the net present value of investments has. It lies in the fact that the value of the indicator must be positive for the project to be considered. It should be rejected if a negative value is received.

It should be noted that the calculated value is rarely zero. However, upon obtaining such a value, it is also advisable for the investor to reject the project, since it will not make economic sense. This is due to the fact that the profit from the investment will not be received in the future.

Calculation accuracy

When calculating NPV, it is worth remembering that the discount rate and revenue projections have a significant impact on the present value. The end result may be inaccurate. This is due to the fact that a person cannot make a forecast for future profit with absolute accuracy. Therefore, the resulting figure is only a guess. He is not immune to fluctuations in different directions.

Of course, the investor needs to know what profit he will receive even before investing. To keep variances as low as possible, the most accurate methods should be used to determine performance in conjunction with net present value. The general use of different methods will allow you to understand whether an investment in a particular project will be profitable. If the investor is confident in the correctness of his calculations, a decision can be made that will be reliable.

Calculation formula

When looking for programs to determine net present value, one may come across the concept of "net present value", which has a similar definition. It can be calculated using MS EXCEL, where it is found under the abbreviation NPV.

The formula used uses the following data:

CFn - amount of money for period n;
N is the number of periods;
i - discount rate, which is calculated from the annual interest rate

In addition, the cash flow for a certain period may be zero, which is equivalent to its complete absence. When determining income, the amount of money is recorded with a "+" sign, for expenses - with a "-" sign.

As a result, the calculation of the net present value leads to the possibility of assessing the effectiveness of investments. If NPV> 0, the investment will pay off.

Application restrictions

When trying to determine what the net present value of NPV will be, using the proposed method, you should pay attention to some conditions and restrictions.

First of all, the assumption is accepted, which is that the indicators of the investment project will be stable throughout its implementation. However, the probability of this may approach zero, since a large number of factors affect the value of cash flows. After a certain time, the cost of capital allocated for financing may change. It should be noted that the figures obtained may change significantly in the future.

An equally important point is the choice of the discount rate. As it, you can apply the cost of capital raised for investment. Taking into account the risk factor, the discount rate can be adjusted. A premium is added to it, so the net present value is reduced. This practice is not always justified.

The use of a risk premium means that only taking a loss is considered by the investor in the first place. He may mistakenly reject a lucrative project. The discount rate can also be the return on alternative investments. For example, if the capital used for investment will be invested in another case at a rate of 9%, it can be taken as a discount rate.

Benefits of using the technique

The net present value calculation has the following advantages:

the indicator takes into account the discount factor;
clear criteria are used when making a decision;
the possibility of using it when calculating the risks of the project.

However, it should be borne in mind that this method has more than just advantages.

Disadvantages of using the technique

The net present value of an investment project has the following negative qualities:

In some situations, it is quite problematic to correctly calculate the discount rate. This is most often the case for multidisciplinary projects.
Although cash flows are predicted, the formula cannot calculate the likelihood of an event occurring. The applied coefficient can take into account inflation, but basically it is the rate of return that is included in the calculation project.

After a detailed acquaintance with the concept of "net present value" and the calculation procedure, the investor can conclude whether it is worth using the method under consideration. To determine the effectiveness of investments, it is advisable to supplement it with other similar methods, which will allow you to get the most accurate result. However, there is no absolute probability that it will correspond to the actual receipt of profit or loss.