Which would you choose? As a sensible person you'd pick Option 1.
If you received $100 today, you can invest it, and in a year
from now you might have $105 if your investment has a return of 5%.
In addition, inflation would steal part of your $100, so
in a year from now, the same bill might buy you only $97 worth of products. We
prefer to get money sooner rather than later, so you’d need some form of
compensation to get the money later.
So Present Value is the value today of an amount of
money in the future.
How about this choice:
- Someone offers you $100 today.
- Someone offers you $105 one year from today.
You get options like this often in everyday life, like the
option to pay upfront for a year instead of making monthly payments.
So, which option would you choose? Basically, you are
offered a 5% return that needs to reimburse you for the loss of investment (i.e.
you can’t do anything else with $100), the risk involved (will you actually get
the $105 in a year from now?), and the expected rate of inflation.
opportunity cost, inflation and risk are used to set something called the
Discount Rate. The Discount Rate is key in calculating NPV and can change the
calculation dramatically based on the discount rate chosen. (Note: Working with your customer to understand their Discount Rate is important)
Let’s assume you could put the money in the bank and would
receive 3% interest. Inflation is currently rather low, let’s say
1%. The person is creditworthy so the risk of not getting paid is extremely low. With
your 3% investment, you’d have $103 in a year. Given 1% inflation,
the $103 would be worth only $101.97.
So if you’d take the $100 today, you’d have 101.97 in
a year. Option 2 would be favorable, as you would get $105.
The NET portion of the term simply refers to all the cash
flows over the term of the project. If you apply the Discount Rate to ever
years cash flow and add them all together you get the Net Present Value.
To Sum Up:
- Net Present Value is a way to value an
investment that takes into account the time factor of money.
- The Discount rate used has a tremendous impact
- A positive NPV means that the project is worth
- A negative NPV means the project will loose
- NPV is a good way to screen projects but is not
a great tool for prioritizing projects because a the size of the project will
impact the NPV
- Engage your customer in a discussion of what the right discount rate to use.
- The higher the discount rate the lower the NPV
How to Calculate Net Present Value
How to Use Excel Formulas to Calculate NPV
David Roberts at Grist has an excellent piece on how setting a discount
rate has tremendous impact on modeling climate change economics.