When we are weighing investment decisions, we typically want to know how much money we will make over and above our investment. It is also helpful to know what the return on our investment is in today's dollars.
Net Present Value is a method for calculating the present value (that is, the value of cash to be received in the future expressed in today’s dollars) of an investment in excess of the initial amount invested. In other words, in today's dollars, how much money will we make after X years of investment, expenses and revenues.
Let's look at the Khan Academy explanation of present value:
Net Present Value is a method for calculating the present value (that is, the value of cash to be received in the future expressed in today’s dollars) of an investment in excess of the initial amount invested. In other words, in today's dollars, how much money will we make after X years of investment, expenses and revenues.
Let's look at the Khan Academy explanation of present value:
And, for further explanation on present value, please review:
Using Excel to calculate the Net Present Value of a series of cash flows is fairly straight forward. In the example below, we want to know if we should buy a duplex for $80,000. We would like to receive at least a 10% return on our investment after 5 years. Our real estate agent assures us that we can sell the duplex in five years for $115,000. We expect to lose money the first year (approximately $500), but then have positive cash flows from renters years 2, 3 and 4.
To calculate the NPV, go to the Formula tab in excel, then click on Financial and find NPV in the list of formulas. Click on NPV and put in .10 for the rate - this is the desired return on investment that we would like. Value 1 is our initial investment of $80,000 and should be entered as a negative number as this is money we are paying out. When you are in the Value 1 window, you can simply click on the initial investment cell of (80,000), then drag your cursor over the five years of cash flows in the adjacent cells.
Or if you prefer, you can enter each of the annual cash flows into a separate value window (value 1, value 2, etc). The result will be the same.
A positive net present value of $1,705 lets us know that our investment is meeting our criteria of at least a 10% return on investment.
Let's return to our example of deciding whether to invest $1,000,000 in Clinic A or Clinic B.
We can use the NPV function to determine in today's dollars, which investment is the better choice, given the different cash flows over time. Because interest rates continue to be low, we will assume a 6% interest rate for our calculations.
The formula bar for Clinic A's NPV calculation looks like this:
=NPV(0.06,N25,O27:T27)
Where N25 is the initial $1,000,000 investment, and O27:T27 are the six years of cash flows.
Both of the NPVs are positive, therefore both are acceptable investments. The cash flow for Clinic B is a little better, and after six years provides us with approximately a $90,000 greater return (in today's dollars).
What other factors should we consider prior to making our investment decision?