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