Present Value (PV) and Net Present Value (NPV)
Explained
1. Present Value (PV)
PV tells us how much a future amount of money is worth today. This considers the time value of
money — that money available now is more valuable than the same amount in the future
because it can be invested.
PV Formula:
Where:
= Present Value (today’s value)
= Future Value (amount you will receive in the future)
= Discount rate (interest or expected rate of return)
= Number of years into the future
Example:
Suppose you expect $1,500 after 4 years and the discount rate is 10%.
Meaning: If you invest $1,027.39 today at 10% annually, it will grow to $1,500 in 4 years.
2. Net Present Value (NPV)
NPV is used to evaluate the overall profitability of a project by considering all cash inflows and
outflows and when they happen.
How to Calculate NPV:
Identify cash flow for each time period (positive = income, negative = expense).
Calculate discount factor for each period:
Multiply each cash flow by its discount factor to get discounted cash flows.
Add all discounted cash flows, including initial investments (usually negative).
Example:
Year Cash Flow ($) Discount Factor (10%) Discounted Cash Flow ($)
0 -1000 1 -1000
1 300 0.9091 272.73
2 300 0.8264 247.92
3 300 0.7513 225.39
4 300 0.6830 204.90
5 300 0.6209 186.27
Total 137.21
Since NPV > 0, the project is profitable at a 10% discount rate.
3. Limitations of NPV
Choosing the discount rate can be subjective and affects the outcome.
Comparing projects with different risk profiles or lifespans can be challenging.
Key Takeaways
PV finds the value today of a single future cash flow.
NPV sums all discounted cash flows of a project, capturing profitability and timing.
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