Every rational investor believes money in hand today is more valuable than money received in the future; as money in hand can be invested to earn profit or something bought today can have higher selling price in future/ even simple deposit with a bank could result into almost risk free return.
Risk associated with receiving money in future: There are several types of risk associated with money being received in future:
- Default Risk/ Credit Risk: Investor may default while making payments.
- Liquidity Risk: Liquidity risk quantifies the risk of impairment in value or receiving less than fair value for an investment in case something is must be sold quickly.
- Maturity Risk: Maturity risk is associated with long term investments; wherein longer maturity investment considered to be risky due uncertainty of macro-economic or political environment.
- Inflation: Future value of money is also impacted by inflation; simply put inflation erodes buying power of money which is also known as time value of money (TVM).
Opportunity Cost: Opportunity cost also known as alternative cost; quantifies the missed opportunity of earning profit from an alternative investment. In economics, opportunity cost is also referred as value of what you have to give up while choosing something else.
What is Net Present Value (NPV)? : Net Present Value measures the impact of inflation or the opportunity cost; wherein NPV of an investment is present value of cash inflows minus the present value of cash outflows. Net present value refers to subtracting present value of cash out flows (cost) from the present value of the cash inflows (benefits) to arrive at net profit/loss.
NPV = Present value of Cash Inflows – Present value of Cash outflows
A positive net present value indicates that the projected earnings generated by a project or investment – exceeds the anticipated costs. It is assumed that an investment with a positive NPV will be profitable, and an investment with a negative NPV will result in a net loss.
How to Calculate NPV? : Following Steps should be followed while calculating NPV.
Step1: Identify all the cash flows associated with any investment; both cash outflows (including initial investment) and cash inflows.
Step2: Decide upon the appropriate discount rate or opportunity cost for the investment.
Step3: Use chosen discount rate to calculate the present values of cash flows (both inflows and outflows; while inflows would be considered as positive cash flows and outflows will be considered negative)
Step4: Sum all the present values calculated in the step 3 to calculate the net present value.
Formula for Net Present Value:
CFt = Represents the cash flow at time t
N = Number of periods
r = Discount Rate or the opportunity cost
NPV rule: As explained above; money in the present is worth more than the money in the future due to impact of inflation or opportunity cost. But what if expected return from an investment is higher than the impact of inflation e.g. if expected inflation for next one year is 5% where as expected return from the investment is 8% then investor might take up the project as project investment would fetch net profit of 3%.
Example: If given an option either to receive $100 today or one year from now; then every rational person would choose $100 today, as $ 100 received today can be invested and interest could be earned. Let us suppose same person given an option either to receive $ 100 today or $ 108 one year from now; this option might end up with person choosing $ 108 one year from now( Let us suppose expected inflation is 5% or the next best possible investment opportunity could fetch only 5% as interest).
Mutually Exclusive Projects: If someone has two investment opportunities and only one of the two opportunities can be availed then investment opportunity with higher NVP should be chosen because basic rule of investment is profit maximization and higher NPV results into higher profit.
Next article will cover NPV calculation in Excel: