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