So let’s start with NET PRESENT VALUE FORMULA это
For example if the NET PRESENT VALUE это of our project “land in the Farmhouse” is negative means that we will have to pay more than what we get paid and if the NET PRESENT VALUE это of our project “land in the Farmhouse” is exactly zero and will break even which means we will be able to pay all our bills but we won’t have a penny left over and with a positive NET PRESENT VALUE это we will walk away with something in our pocket.
To find out how much exactly we will walk away with requires a bit more analysis. The finding of value is the first step so let me demonstrate how this works with an example.
Let’s say you’ve completed a zero-based budget for two different projects.
NET PRESENT VALUE это For Project 1
One is three years long and you can get a 5 percent interest rate loan for it and the net cash flow starting at year 0 with cash flows as $(10,000.00) $(5,000.00) $20,000.00 $30,000.00
NET PRESENT VALUE это For Project 2
The other five years you can get a 20 percent interest rate loan for it and the net cash flow starting at year 1 are
$(30,000.00) $20,000.00 $40,000.00 $(10,000.00) $50,000.00
NET PRESENT VALUE FORMULA” width=”1024″ height=”378″ />
The point to be noted is that these two projects are mutually exclusive meaning that you only have enough money to do one, so how would you decide between the two? Which one is a better investment?
Well, certainly you could add up the cash flows into the project. One will leave you $35000 ahead and the second project will put you $60000 ahead.
It seems like a no-brainer. Except for that nagging little thought, but it’s not quite that simple and guess what.
That nagging little thought is not right when investments have different lengths different interest rates and different cash flows. The only way they can accurately be compared is to find the present values of each project and rates of interest and time effects, we need to get each project down to its worth in today’s Value e.g. Dollars.
So it can be compared and let’s do this for Project 1.
Project 1 Cash Flows.
Except for the year zero cash flow represents dollars we expect to materialize in the future so these are our future values. Our Net Cash Flows are our future values but we haven’t calculated our discount factors yet.
So let’s do that.
The formula for Discounting = (1 (1+r)i)
Project 1 Rate = 5%
(1 (1+0.5)0) = 1
(1 (1+0.5)1) = 2
(1 (1+0.5)2) = .95
(1 (1+0.5)3) = .91
(1 (1+0.5)4) = .86
Figures are rounded to two decimal points for simplicity. Although normally we would carry these out four places. Now let’s just look at our results.
You see it is the value of one dollar dropping which means if you have to wait a year to get paid that dollar is only worth 95 cents to you today.
In today’s money and after two years the value of a dollar has dropped to 91 percent. You get the Concept.
The longer you have to wait for your money the less its worth to you today”
So now we multiply our future value amounts by these discount factors and find out what each is really worth in today’s dollars.
Now I’d like you to calculate NET PRESENT VALUE это and find the NET PRESENT VALUE это NPV of project 2.
Just so you can compare your results.NET PRESENT VALUE это of Project 2 is $27,308