How to Calculate Net Present Value: Definition, Formula & Analysis

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Lesson Transcript
Instructor: Anthony Aparicio

Tony taught Business and Aeronautics courses for eight years; he holds a Master's degree in Management and is completing a PhD in Organizational Psychology

The value of money changes over time. If you spoke to your parents or grandparents about what things cost when they were children, you will see a big difference. This concept is called net present value.

Definition of Net Present Value

Net present value (NPV) refers to the concept that the value of money changes over time. Even though one dollar in 1920 is still called a dollar today, the amount of things that one dollar buys has changed. Something that cost \$20 back in 1920 would cost around \$239 today because of the rate of inflation.

NPV is a common technique used in business to determine how to select the best investment based on its value at one point in time (usually the present). Companies prefer to get their money back from their initial investment as quickly as possible so that they can do the same thing again with future investments. In order to figure out whether an investment will be worthwhile, the manager or accountant must calculate the value of future revenue in today's dollars.

Computing Simple NPV with Example

Simple NPV is when you are dealing with one investment and return with no payments in between. To give an example of simple NPV, say that you are asked to loan your brother \$4,000 for a car, and he said that he will pay you back in two years when he graduates college.

Before calculating the NPV, you will have to first discuss the cost of capital. The cost of capital is the amount you would be losing if you did not invest the money somewhere else. If you are thinking of lending money, you also have the option to keep that \$4,000 in an investment that could have earned you interest. Use the example of an expected 5% return on your investment. Therefore, 5% is your cost of capital.

If you do decide to loan your brother the money and you have determined that 5% is your cost of capital, what is the value of that \$4,000 two years from now?

Compute NPV by first:

1. Determine the amount. In this example, the amount is \$4,000.
2. Then, determine the cost of capital (5%) and the number of periods. The period is 2 years because that is how long it will be until your brother pays you back.
3. Next, look up the present value of 1 table at the intersection of the percentage and the period.
4. Finally, multiply the decimal found on the table by the initial amount.

If you search the Internet, you will find a special table called the Present Value of 1. Once you have found it, look at the intersection between the 5% column and 2 periods (years in this case). You will see that there is a decimal number of .9070.

Take the amount you are going to loan your brother (\$4,000) and multiply that by the decimal number you found at the intersection of the appropriate column and row (.9070).

\$4,000 x .9070 = \$3,628

Based on this example, if your brother paid you back exactly \$4,000 in two years, it will only be worth the equivalent of what \$3,628 dollars is now.

A company has two investment choices that cost \$3,000 each: one that brings in \$10,000 in revenue at 8% interest in two years, and another that brings in \$11,000 revenue at the same interest rate in five years. Use the Present Value of 1 table to compute the value of each investment and see how they compare.

What is the present value of \$10,000 revenue in two years?

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