Net Present Value determines the value of an investment by taking into consideration the cost of capital and the cashflows of the investment over the life of the investment.
What is Net Present Value
Net present value is one method of determining the value of an investment. It does this by calculating the cost of the investment compared against the cashflows that the investment will generate. It also takes into consideration the time value of money.
So what exactly does this mean in practicality and how can you use it to make a decision? First it is important to know exactly how it is calculated and this starts with the formula.
i = Cost of Capital (Interest rate on loan or the cost of borrowing)
t = Time Frame (This may be in days, months or years)
So letâ€™s have a quick look at an example investment.
At the time of writing in early 2020 interest rates around the world are extremely low. So we will look at a real estate investment as our example.
We will use the first 5 years of the investment as a time frame with a 3.85% cost of capital. This is a simple figure based only on the mortgage interest rate. We will also assume an initial investment of $40,000 of personal capital as a 10% deposit. We will also use the 5% rule and base our calculations on $400 per week rent. This results in cash flows of $20,800 per year for a total of $104,000 over the 5 years.
As with any formula we will solve inside the brackets first.
(1 + 0.0385)^5 = 1.207904236
We then divide our Cash flow by $104,000:
This gives us cash flows adjusted over time of $86,099.54. If we then subtract our initial investment of $40,000 this gives a net present value of $46,099.54.
This actually represents a net return on investment of approximately 23% per year over the 5 years that we are looking at. This is a respectable return.
Using Net Present Value
We use the Net Present Value calculation to determine the value of an investment. Using the formula as weâ€™ve stated it above will get a very simple answer.
We can use this to determine important factors about the investment. First thing we can see is whether it is a positive number or not. If the answer is a negative number then it is definitely a bad investment. This means that we are losing money.
If we take the NPV and divide it by the number of years then we get our Average Annual Rate of Return (AARoR). In our example we used 5 years so in this case it is $9,219.91. If we then compare this to our initial investment we see that this is an AARoR of 23.05%. As we said earlier this is a respectable ROI.
However, one of the strengths of this calculation is when we use it to compare multiple investments side by side.
If we had 3 investments that were all very similar then we could look at the Net Present Value of each and compare them. We could then determine which had the better value as an investment by having the higher NPV.
- Our first example was a 5 year investment at 3.85% cost of capital with $20,800 per year in cash flows and a $40,000 initial investment.
If we compare this with the following examples.
- A 4 year investment at 4.5% cost of capital with $20,000 per year in cash flow and a $20,000 initial investment.
- A 3 year investment at 4.15% cost of capital with 25,000 per year in cash flows and a $25,000 initial investment
We can see that option number 2 has the higher net present value and is under this method the better investment.
Mapping Net Present Value over the Term of the Investment
Itâ€™s possible to chart the value of the net present value over the period of the investment and see where it will be at at a variety of points throughout its life.
We do this by charting the information in a table and making the calculation of NPV at different points in time.
When we take our example from early which is a 5 year investment, we can chart our investment more accurately. By doing this we know exactly where our investment will be at each year of the investment.
Cost of Capital | 3.85% | |||
YEAR | CASH FLOW | COST | NPV | CUMULATIVE NPV |
0 | $â€Ž (40,000.00) | $1.00 | $â€Ž (40,000.00) | $â€Ž (40,000.00) |
1 | $â€Ž 20,800.00 | $1.00000 | $â€Ž 20,800.00 | $â€Ž (19,200.00) |
2 | $â€Ž 20,800.00 | $0.92448 | $â€Ž 19,229.23 | $â€Ž 29.23 |
3 | $â€Ž 20,800.00 | $0.88889 | $â€Ž 18,488.91 | $â€Ž 18,518.14 |
4 | $â€Ž 20,800.00 | $0.85467 | $â€Ž 17,777.08 | $â€Ž 36,295.22 |
5 | $â€Ž 20,800.00 | $0.82176 | $â€Ž 17,092.66 | $â€Ž 53,387.88 |
TOTAL | $â€Ž 64,000.00 | $â€Ž 53,387.88 |
The table above takes all of the information from our NPV formula and calculates it out for each year. Our cash flow column illustrates the annual cashflow the investment generates.
The cost column shows the value of $1 minus the cost of capital since the start of the investment. This is also referred to as the time value of money.
In the NPV column we can see the net present value for the current year while the cumulative column shows the cumulative value including the initial investment.
Once this table is set up then you only need to change the values for the cost of capital and the annual cash flows to get the net present value.
Conclusion
Net Present Value is a single calculation that can be used to determine a number of factors about an investment. Itâ€™s not the only way, however, itâ€™s a way to determine the value of one investment against another. It takes into account the cost of capital and the cash flows that will be generated throughout the life of the investment.
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