Writing in the Harvard Business Review (reference below, link on right), Amy Gallo uses the following definition from Joe Knight:
“Net present value (NPV) is the present value of the cash flows at the required rate of return of your project compared to your initial investment. … In practical terms, it’s a method of calculating your return on investment, or ROI, for a project or expenditure. By looking at all of the money you expect to make from the investment and translating those returns into today’s dollars, you can decide whether the project is worthwhile.”
Gallo notes that:
“Most people know that money you have in hand now is more valuable than money you collect later on. That’s because you can use it to make more money by running a business, or buying something now and selling it later for more, or simply putting it in the bank and earning interest. Future money is also less valuable because inflation erodes its buying power. This is called the time value of money. But how exactly do you compare the value of money now with the value of money in the future? That is where net present value comes in.”
“No one calculates NPV by hand, Knight says. There is an NPV function in Excel that makes it easy once you’ve entered your stream of costs and benefits … Many financial calculators also include an NPV function. “A geek like me, I have it on my iPhone. I like to know it’s in my pocket,” says Knight.
“Even if you’re not a math nerd like Knight, it’s helpful to understand the math behind it. “Even seasoned analysts may not remember or understand the math but it’s quite straightforward,” he says. The calculation looks like this:
This is the sum of the present value of cash flows (positive and negative) for each year associated with the investment, discounted so that it’s expressed in today’s dollars. To do it by hand, you first figure out the present value of each year’s projected returns by taking the projected cash flow for each year and dividing it by (1 + discount rate). That looks like this:
Gallo concludes her article with:
“There are three places where you can make misestimates that will drastically affect the end results of your calculation. First, is the initial investment. Do you know what the project or expenditure is going to cost? If you’re buying a piece of equipment that has a clear price tag, there’s no risk. But if you’re upgrading your IT system and are making estimates about employee time and resources, the timeline of the project, and how much you’re going to pay outside vendors, the numbers can have great variance.
“Second, there are risks related to the discount rate. You are using today’s rate and applying it to future returns so there’s a chance that say, in Year Three of the project, the interest rates will spike and the cost of your funds will go up. This would mean your returns for that year will be less valuable than you initially thought.
“Third, and this is where Knight says people often make mistakes in estimating, you need to be relatively certain about the projected returns of your project. “Those projections tend to be optimistic because people want to do the project or they want to buy the equipment,” he says.”
Atlas topic, subject, and course
Sources
Amy Gallo (2014), A Refresher on Net Present Value, Harvard Business Review, 19 November 2014, at https://hbr.org/2014/11/a-refresher-on-net-present-value, accessed 29 January 2018. Gallo draws on her interview with Joe Knight, co-author of Financial Intelligence: A Manager’s Guide to Knowing What the Numbers Really Mean and co-founder and owner of www.business-literacy.com.
Page created by: Ian Clark, last modified 29 January 2018.
Image: Amy Gallo (2014), A Refresher on Net Present Value, Harvard Business Review, 19 November 2014, at https://hbr.org/2014/11/a-refresher-on-net-present-value, accessed 29 January 2018.
