Estimated reading time: 4 minutes
When evaluating your business’s finances, there is no time like the present. After all, the amount of money you have stashed away is more valuable than the sales receipts and receivables you will collect in the future. You can use the cash now to pay bills and expenses and keep your company moving forward. Or, you can keep it in the bank and generate interest.
Next, the money you will make in the future might not be as valuable as it is today. There are several reasons for this. For example, the costs associated with running a business can increase. Goods, services, supplies, labor, and rent typically cost more money over time. When these and other business-related costs rise, you most likely have to raise your prices to make ends meet and generate a profit.
As you know, the rate of increase in prices over a specific period is known as inflation, and inflation decreases consumers’ buying power. So, how can you measure the value of money today with the value of money in the weeks, months, or years ahead? This Balboa Capital blog article answers that question. It features a refresher on net present value (NPV) and explains why it is essential.
Net present value definition.
Net Present Value (NPV) is a measure of the profitability of an investment. Specifically, it is the difference between an investment and the future cash flow from the investment in today’s dollars. NPV is a discounted cash flow technique that can be used to evaluate potential investments. The NPV will be positive if it’s a profitable investment and negative if it’s not profitable.
The net present value of an investment is a measure of how much it will be worth in the future, taking into account any taxes that will be paid on it in the future. It’s also important to consider how long you have before you need to use your investment. Knowing the difference between NPV and return on investment (ROI) is essential. Both of these are used to evaluate the potential profitability of business investment, but ROI, unlike NPV, does not consider the present value of money. For this reason, you may want to consider calculating both NPV and ROI.
NPV formula.
The NPV formula is unlike most business formulas, which involve basic accounting knowledge and are relatively easy to learn. But do not let that deter you, as the results of your NPV calculation can provide you with valuable insight into your investments, such as equipment, machinery, technology, or software. If your company has an accountant on staff, they should be able to calculate your net present value using accounting software or a financial calculator. Excel is even equipped with an NPV function that can be used once the costs are entered in the appropriate cells.
On the surface, the formula for net present value is pretty simple. The Rt equals the net cash flow at the time (t); i equals the return (or discount rate), and t equals the time period(s) of the cash flow. Following is the formula:
NPV = Rt divided by (1 plus i)t
NPV example.
To better illustrate how the NPV formula works, here is an example. The owner of a welding company invested $10,000 in new equipment today and gets back $12,000 after one year, with an annual return of 10%.
- Amount invested: $10,000
- Money received after 12 months: $12,000
- Rate of return: 10% = 0.1
- Present Value = Cash value at the time period divided by (1 + rate of return) time period
- $12,000 divided by (1 plus 0.1)1
- Net Present Value: $10,909 (+$909)
Interpreting the results.
The time value of money is the concept that a dollar today is worth more than a dollar tomorrow. This is because the dollar today can be invested and earn interest. The net present value of an investment is a measure of how much it will be worth in the future, taking into account any taxes that will be paid on it in the future.
It’s also important to consider how long you have before you need to use your investment. A higher NPV indicates that the investment has proven successful from a financial perspective. In contrast, a negative NPC reveals that the investment is actually losing money and not generating a positive return. Obviously, the higher the NPV, the more profitable the investment.
Summary.
Net present value is an essential tool for assessing the profitability of a project or investment. It is also a key metric for evaluating investments in capital-intensive assets like heavy equipment and office buildings. Investments that yield a positive NPV add value to businesses and can help boost revenues and market share.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.