The Net Present Value
The Net Present Value (NPV) is one of the most crucial concepts in financial management. Its fundamental idea is based on the principle of "the time value of money". This principle asserts that a sum of money you will receive a year from now is worth less than the same amount if you had it today. This leads to another concept known as the "discount factor".
What is the Discount Factor?
The discount factor is the tool that allows us to calculate the present value of an amount that will be received in the future. For example, assuming the discount factor is the return on a yearly savings certificate in a certain country, and let’s say this return is 12%, then the present value of 100,000 dollars to be received after a year is calculated as follows:
Present Value} = 100,000/(1 + 0.12) = 89,258.7 dollars.
This means that if someone offers you 100,000 dollars after a year or 90,000 dollars today, based on the discount factor and present value calculations, the 90,000 dollars today would be worth more.
What Happens if You Receive the Money in Installments?
The situation becomes more complex when the amount is received in separate installments over different periods of time. Let’s consider this scenario:
- 20,000 $ as an upfront payment.
- 5,000 $ every six months for three years.
- 50,000 $ as a lump sum six months after the last 5,000$ installment.
Now, if someone offers you 70,000 $ in cash instead of these periodic payments, which option is better? Let's calculate the present value of the total installments using a 12% annual discount factor:
NPV = 20,000 + 5,000/(1.12)^0.5 + 5,000/(1.12)^1 +......+ 5,000/(1.12)^3 + .... + 50,000/(1.12)^3.5 = 78,346.91 $.
Based on this calculation, the present value of the installments is 78,346.91 $, which means that the 70,000 $ offered upfront is less than the present value, making it the less favorable option.
The Importance of Calculating Net Present Value
Calculating the present value of a series of future cash flows is fundamental to determining real profit and loss. You may be deceived into thinking you’re making a profit when, in reality, you are only accounting for it, while your actual value is declining.
How is the Discount Factor Determined?
The determination of the discount factor depends on several methods and criteria, and each method will yield a different result for the Net Present Value. In the next article, we will explore how to calculate the discount factor and its impact on financial decisions.
Stay tuned for the next article, where we will dive deeper into how discount factors are determined and their effect on financial decision-making.