Net Present Value Definition
The following video is borrowed from our BusinessTraining.com platform and was originally recorded for our financial analyst training program. In this video, you will learn the definition of Net Present Value and how that calculation is used in financial analysis.
Video Transcript/Summary: The strategies and tips provided within this video module include:
- Money has a time value. The amount you receive today is the Present Value. The amount you receive at some future date is known as a Future Value. To determine the attractiveness of opportunities, future cash flows need to be discounted to the present value, using a discount rate (interest rate).
- Discount factor is equal to the PV of $1 and is calculated as 1/(1+r)t. The present value equals the discount factor (DF) multiplied by Cash Flow (Ct).
- To calculated the Net Present Value, the PV of future cash inflows and PV of future cash outflows is required. In order to determine the discount rate to use, identify the opportunity cost of capital (i.e. an alternative or second best option). If the alternative return is 12%, use this as our discount rate.
- A project evaluation requires that options are gathered, evaluation is conducted on the second best option, assumptions are reached for both scenarios, cash flows calculated within the project life, cash flows discounted to the present to get NPV and results need to be be risk adjusted.
- As an example, what is the PV of $400 in 1 year at 7% or 12% cost of capital? At 7%, the answer is $374 and at 12% it is $357. Therefore, the higher the cost of capital, the lower the PV. Higher risk project as a result require higher rated returns.
- You should accept projects where the rate of return is greater than than the cost of capital. You should also accept projects with NPV greater than 0.
- When treating depreciation, deduct it to determine profit before tax but add it back once tax has been calculated as depreciation has no effect on cash flows.
- In summary, money has time value, when deciding on investments we need to compare NPVs, accept investment where the rate of return is greater than the opportunity cost of capital and NPV is positive, evaluate projects versus the second best option, cash flows need to be discounted and result need to be risk adjusted.
I hope that this video has provided you with a complete definition of Net Present Value.
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