Eli5: What is NPV (Net Present Value) in the most simplest terms? I have a non-finance background


Eli5: What is NPV (Net Present Value) in the most simplest terms? I have a non-finance background

In: 5

The value of money depends on when you get it. Getting 100$ today is better than getting 200$ in 30 years. Not only because of inflation but because if you want to spend 100$ now you’d have to take a loan and pay interest for 30 years. The earlier you get money the better, the later you pay something the better, makes sense?

Okay NPV tries to normalize that so money at different timepoints becomes comparable. Project A makes me 1 million next year, Project B makes me 1.3 million the year after, wich one is better?

NPV basically corrects every value to “now” by subtracting/adding the assumed interest rates

Risk is the number one thing being evaluated when determining if a financial decision is correct but there are other factors. Money today is worth more to me than money tomorrow. Net present value is how we quantify this concept, we use it to sort cash flows in order of payout, soonest first.

What should this be worth to you RIGHT NOW. That is what NPV is. “This” could be an investment, loan, purchase etc.

The key fundamental concept is TVM – Time Value of Money. A dollar today is worth more than a dollar tomorrow because you can invest that dollar and earn something on it by tomorrow.

Using NPV, the idea is to value any activity in terms of today’s dollar. So they can be easily compared. The hyperbolic way to think of it is “would you prefer to be given $1,000 today or $10,000,000,000 in 200 years”. Since you’re almost certainly dead in 200 years, the rational answer would be $1,000 today even though $10,000,000,000 is a lot more money. That $1,000 now is more valuable to you and that is the idea behind NPV.

“A bird in the hand is worth two in the bush.”

Or conversely, expected future income should be discounted, because … you might not get it for some reason, or inflation *will* reduce its worth, or the opportunity cost of not having it now.

Simply put, the PV (present value) of money is the amount you would need to invest today to have that amount in the future.

So, say you’re expecting a $500 bill in a year. Depending on the interest rate, that’s worth less than $500 today, because you could invest, say, $450 today and it will have grown to $500 through interest by the time you need to pay it. So what is the “present” value of that $500 bill? $450, because that’s what you actually need today to be able to pay it when it’s due.

Companies use this for future profit. If you expect a product to make $1000 next year, how much would they need to invest today to make the same amount? That’s the PV (present value) of that cash flow. If the product is expected to make $2000 the year after that? The amount you’d invest to make $2000 in two years is the PV of that cash flow. You can find the PV of all the cash flows you expect over a number of years, add them up, and compare that to the cost it would take to develop and sell the product, usually by subtracting the cost from the PVs of the profits. That’s the ‘Net’ Present Value. If the NPV is negative, that means the present values of the cash flows (profits) the product will bring in over the years is less than the initial cost to develop the product. That means it’s not worth it, because you could make the same amount or more just by taking the money you’d have spent developing the product and investing it, and letting it grow.

So basically, NPV allows you to compare money in the future to money now by pretending all future money is money you invest today and take out in the future, and removing the ‘interest’ from that amount, leaving just what you would need to invest today.