If you were offered $100 today or $100 a year from now, which would
you choose? Would you rather have $100,000 today or $1,000 a month for
the rest of your life?
Net present value (NPV) provides a simple way to answer these types
of financial questions. This calculation compares the money
received in the future to an amount of money received today, while
accounting for time and interest. It's based on the principle
of time value of money (TVM), which explains how time affects
monetary value.
The TVM calculation may look complicated, but with some understanding
of NPV and how the calculation works, along with its basic
variations: present value and future value, we can start putting this
formula to use in common application.
*Tutorial*: Fundamental Analysis
Time Value of Money
If you were offered $100 today or $100 a year from now, which would be
the better option and why? This question is the classic method in
which the TVM concept is taught in virtually every business school in
America .
The majority of people asked this question choose to take the money
today. But why? What are the advantages and, more importantly,
disadvantages of this decision?
There are three basic reasons to support the TVM theory. First, a
dollar can be invested and earn interest over time, giving it
potential earning power. Also, money is subject to inflation, eating
away at the spending power of the currency over time, making it worth
less in the future. Finally, there is always the risk of not actually
receiving the dollar in the future - if you hold the dollar now,
there is no risk of this happening. Getting an accurate estimate of
this last risk isn't easy and, therefore, it's harder to use in a
precise manner.
Illustrating the Net Present Value
Would you rather have $100,000 today or $1,000 a month for the rest of
your life?
Most people have some vague idea of which they'd take, but a net
present value calculation can tell you precisely which is better, from
a financial standpoint, assuming you know how long you will live and
what rate of interest you'd earn if you took the $100,000.
Specific variations of time value of money calculations are:
* *Net Present Value* (lets you value a stream of future payments
into one lump sum today, as you see in many lottery payouts)
* *Present Value*(tells you the current worth of a future sum of
money)
* *Future Value* (gives you the future value of cash that you have
now_)_
*Determining the Time Value of Your Money*Which would you prefer:
$100,000 today or $120,000 a year from now?
The $100,000 is the "present value" and the $120,000 is the "future
value" of your money. In this case, if the interest rate used in the
calculation is 20%, there is no difference between the two. *Five
Factors of a TVM Calculation.*1.Number of time periods involved
(months, years)
2.Annual interest rate (or discount rate, depending on the
calculation)
3.Present value (what do you have right now in your pocket)
4.Payments (if any exist. If not, payments equal zero)
5.Future value (the dollar amount you will receive in the future. A
standard mortgage will have a zero future value, because it is paid
off at the end of the term)
Many people use financial calculators to quickly solve these TVM
questions. By knowing how to use one, you could easily calculate a
present sum of money into a future one, or vice versa. The same goes
for determining the payment on a mortgage, or how much interest is
being charged on that short-term Christmas expenses loan. With four of
the five components in-hand, the financial calculator can easily
determine the missing factor. To calculate this by hand, the formulas
for future value (FV) and present value (PV) would look like this:
*Applying Net Present Value Calculations*
Net present value calculations can also help you discover answers to
other questions. Retirement planning needs can be determined on an
overall, monthly or annual basis, as can the amount to contribute for
college funds. By using a net present value calculation, you can find
out how much you need to invest each month to achieve your goal. For
example, in order to save $1 million dollars to retire in 20 years,
assuming an annual return of 12.2%, you must save $984 per month. Try
the calculation and test it for yourself.
Below is a list of the most common areas in which
people use net present value calculations to help them make decisions
and solve their financial problems.
* Mortgage payments
* Student loans
* Savings
* Home, auto or other major purchases
* Credit cards
* Money management
* Retirement planning
* Investments
* Financial planning (both business and personal)
*The Bottom Line on Net Present Value*The net present value
calculation and its variations are quick and easy ways to measure
the effects of time and interest on a given sum of money, whether it
is received now or in the future. The calculation is perfect for
short- and- long-term planning, budgeting or reference. When
plotting out your financial future, keep this formula in mind.
*by Daniel Myers*,CFA
Daniel Myers has earned the CFA designation, and has managed money for
investors since 1998.
Source: Investopedia.Com
