A Refresher on Net Present Value
By Mary Smith
A Refresher on Net Present Value
Net present value (NPV) is a financial concept that illustrates the value of an investment or project in terms of its current worth. NPV considers the time value of money, which accounts for both the amount invested and how much time has passed since investing. It’s important to understand net present value because it can help them make decisions about their business investments. Jonathan Osler provides a refresher on NPV in this article.
The Time-Value of Money
Net present value calls for the concept of the time value of money to be taken into consideration. The time value of money refers to how much a dollar is worth at a given point in time. This plays a significant role when considering NPV because it helps determine if an investment will be profitable over time. For example, let’s say they have $100 today and would like to know what that amount could be worth 10 years from now. By using the concept of the time value of money, they can see that through simple interest rates, their $100 could grow to approximately $163 in 10 years.
As an investor, knowing how much their initial investment would be worth 10 years later is beneficial information to provide when considering whether to invest. Consider this example: they would take the deal if someone offered them $88 today in exchange for $110 10 years from now. Then, through net present value calculations, they can see that their investment would yield a return of approximately 19 percent ($110 / $88).
Net Present Value Formula
According to Jonathan Osler, the net present value formula factors in the initial investment, time, and interest rate to determine how much a project or investment will be worth at a given point in time. This calculation takes into consideration that money could have been made from investing elsewhere with an equivalent return.
The importance of this information is illustrated by Osler, who states, “Investors might want to know if it’s better to spend $500 next year on a new advertising campaign for their business or wait five years until they can buy a new warehouse for product storage. It is only by using the concept of net present values that they are able to make that choice” (Osler).
NPV application to Decision Making
Net present value is very helpful when considering business investments. Because the time value of money plays a role, it’s important for them to consider their initial investment and how long they are investing the money for and what the return on that investment will be. As stated by Osler, “The longer they have the funds invested in the project or business activity, all things being equal, the greater the net present value will be because there is more opportunity to earn interest on their investments” (Osler). When deciding whether to invest in a new project or venture with no prior experience using NPV can help them determine …read more
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