Net Present Value (NPV)
Another time value of money concept that has to do with serial payments is net present value, or NPV. This calculation is a more complex version of the basic present value calculation mentioned earlier. Under a net present value calculation, the present value of each future cash inflow and outflow is figured. Then the results are added to determine whether, in the present, the project has a positive value or negative value for a company or investor.
For example, if a company was going to invest $10,000 today, receive $4,000 each of the next three years, and then have to pay an additional $1,000 to exit the investment, an investor or company would want to know if they’re losing money when the time value of money is considered.
Assuming an 8% annual interest rate, the calculation may look something like this, with the present values of money flowing out represented by negative numbers and money flowing in represented by positive numbers:
|
|
Cash Flows |
Formula |
Present Value |
|
Initial Investment |
– $10,000 |
– $10,000 |
– $10,000 |
|
Year #1 Payment |
+ $4,000 |
+ $4,000 / (1.08) |
+ $3,704 |
|
Year #2 Payment |
+ $4,000 |
+ $4,000 / (1.08)2 |
+ $3,429 |
|
Year #3 Payment |
+ $4,000 |
+ $4,000 / (1.08)3 |
+ $3,175 |
|
Final Investment |
– $1,000 |
= $1,000 / (1.08)3 |