Net Present Value explained.
Which would you prefer someone to give you: one dollar today or a dollar a year from now? Of course the answer is “today”: one could take the dollar today, put it in a savings account and wind up with more than a dollar in a year. While the answer to this question is pretty obvious, it illustrates what Present Value (PV) can tell us. Present value calculates what a future payment (or series of payments) are worth today, assuming some kind of interest rate. It’s a different look at the question: if I invest a dollar today, what will it be worth in a year? They both will reveal the same conclusion, but PV brings everything back to today rather than at some point in the future.
Now let’s try something harder: $1.00 today vs $1.45 in seven years. The answer: it depends. It depends on how much you could earn in a savings account. The higher interest the rate, the higher the future payment must be in order to make the future payment worth more than the initial dollar. If you can get 20% interest, $1.45 in seven years is isn’t much. If you can only get 1%, that $1.45 looks pretty good. In this case, the break-even point is 5.5% interest. If you feel that you can earn more in interest than 5.5%, take the dollar now. If you can’t, take the $1.45 in seven years.
That’s it. Net Present Value (NPV), Discounted Cash Flows (DCF), Weighted Average Cost of Capital (WACC) and Discount Rate are all just variations of the concepts of Present Value and the interest rate.
Multiple payments and investments: PV can be used to determine what a series of investments and returns over time are worth today.
NPV: The same as PV, just subtracting off the initial investment. This means that if the result is a positive number, you will make more money than sticking the investment in a savings account. Less than zero, keep your money in the bank. If I buy a hot dog cart today for $10,000 and think that I will net $3,000 every year for 5 years, the NPV will tell me if it’s a smart investment from a financial point of view.
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DCF: Same as NPV. Cash flow because the money can be outflows (investments and costs) and inflows (returns and receipts). Discounted, because future cash flows are reduced, or discounted, by the interest rate.
WACC: Serves the same purpose as interest, but takes into account that the money invested may come from multiple sources with multiple interest rates. If you are investing $1,000 and half of that comes from a bank with 4% interest and half from an investor that demands 8% interest, your WACC is 6%.
Discount Rate: Same as WACC, mostly. Discount rates are often adjusted based on the current situation and the strategic needs, and can be a bit of an art form.
All of this illustrates the concept of the Time Value of Money. That is, money in the future isn’t worth as much as money today due to interest. And inflation, but that’s another article.
If you have any questions about this article, would like to see an Excel worksheet with all of the above examples or talk about how I can help you and your business make better investment decisions, contact me at 617-855-5439 or jmarcos@complexityclarified.com.