Net Present Value (NPV) is a calculation of the value of future cash flows in present-day currency.
A dollar in your hand today is considered to be worth more (or possibly less) than a dollar in a year's time, because of:
Never invest in a project with negative NPV, unless there are strategic or other compelling reasons to do so. However, remember to also consider the CostOfDoingNothing.
NPV is one of those reasons that managers are always pushing to get software projects completed as soon as possible. Getting paid today is better than getting paid tomorrow.
The formula for calculating NPV is
NPV = future_dollars * (1 + discount_rate) ^ (- number_of_periods)For example, with a discount rate of 10%, one dollar to be received a year from now is worth
1.00 * (1 + 0.10)^(-1) = 0.90909in today's dollars. A dollar to be received three years from now is worth
1.00 * (1 + 0.10)^(-3) = 0.75131Discount rates are based upon inflation, interest rates, and uncertainty. A risky project has a higher discount rate than a less risky project. The discount rate is sometimes called the hurdle rate, because a project with a high discount rate needs a larger payoff to be worthwhile.
What must keep in mind is that all of the factors used to determine this value, ie discount_rate (interest_rate, inflation), number_of_periods, are estimates, as is the calculated value.
Another way to look at NPV is to ask "How much money in a bank today would it take to generate the specified cash flow?". Sometimes this is useful, sometimes it is not.
For example, to generate $1.00 in one year, if the current bank interest rate is 10%:
x + .10 x = 1 1.1 x = 1 x = 1/1.1 x = .909090(...)Same answer :)
This approach is especially useful for evaluating continuing, constant cash flows. For example, what is the net present value of $20,000 per year (starting now, for eternity)? At 10% interest, you would need $200,000 in the bank to generate said stream. Hence NPV = $200,000.
For more info, see http://en.wikipedia.org/wiki/Net_present_value
CategoryEconomics, CategoryMath, EigenValue, MatrixFactoring, FuzzyMath?, FutureDiscounting