net present value explained in a clear
and simple way in just a few minutes two
steps first understanding the idea of
present value and future value and then
net present value present value and
future value are closely related
concepts an example of future value is
how much money will I have one year from
now if I have asked $100 at an expected
20% and you'll return $100 multiplied by
1 point 2 is 120 dollars an example of
present value is how much money do I
invest today to achieve 120 dollars one
year from now at an expected 20% annual
return 120 dollars divided by 1.2 is
$100 so to get to the future value you
move from left to right take a present
value and multiply it by one plus the
rate of return to get to the present
value you go from right to left
take a future value and divide it by one
plus the rate of return you can do this
from multiple years as well how much
money will I have two years from now if
I invest $100 at an expected 20% and
you'll return $100 x 1.2 is $120 this
120 dollars in turn multiplied by 1.2 is
144 dollars how much money do I invest
today to achieve 144 dollars two years
from now and then expected 20% annual
return 144 dollars divided by one point
2 is 120 dollars then divide the 120
dollars once again by 1.2 to get to $100
today the formula for future value is
100 dollars times one point two to the
power two equals 144 dollars in other
words present value times one plus the
rate of return to the power of the
number of years equals future value the
formula for present value is 144 dollars
divided by one point two to the power
two it
one hundred dollars in other words
future value divided by one plus the
rate of return to the power of the
number of years equals present value
let's perform a net present value
calculation step by step what is the
present value PV of all the cash inflows
and cash outflows of the following
project the project is expected to
provide four years worth of benefits of
nominally four hundred dollars per year
and an investment today of one thousand
dollars to launch the project what is
the present value of a four hundred
dollar benefit that we expect one year
from now take the nominal amount of four
hundred dollars and divided by one plus
the weighted average cost of capital
weighted average cost of capital or WAC
is a calculation of a firm's cost of
capital in which each category of
capital is proportionately weighted we
take a fairly high whack of 20% in this
calculation one plus twenty percent
equals one point to four hundred dollars
divided by one point two equals three
hundred and thirty three dollars the
present value of a nominal amount of
four hundred dollars one year from now
is three hundred and thirty three
dollars as today's equivalent what is
the present value of a $400 benefit that
we expect two years from now to
calculate that present value
we need to take the nominal amount of
$400 and divided by one plus 20% to
power two as we need to take two steps
from a year to two year one from year
one to date today this is the same as
saying four hundred dollars divided by
one point two times one point two or
four hundred dollars divided by one
point forty four which is two hundred
and seventy eight dollars next we
calculate the present value of the $400
benefit that we expect three years from
now and the present value of the $400
benefit that we expect fro years from
now we have now translated all cash
flows into today's equivalent to get to
NPV you simply sum the amounts 333 to 78
plus 231 plus 193 minus 1000 if
today the net present value is $35 the
word net in the term net present value
means deducting the investment amount
from the present values of the future
cash flows as the net present value of
this project is positive it is worth
pursuing accept project proposal as it
creates value for the company if the net
present value of the project would have
been negative it would not be worth
pursuing reject the project proposal as
it does not create value for the company
the main idea of net present value is
very simple
time is money the net present value
method takes the time value of money
into account by translating all future
cash flows into today's money and then
ending up today's investment and the
present values of all future cash flows
want to learn more about Business and
Finance then subscribe to the finest
storyteller YouTube channel thank you