Investments will be justified only when they contribute to the creation of new values for the owner of capital. In this case, the value of these values is determined in excess of the cost of their acquisition. Of course, the question arises as to whether it is possible to evaluate them more than real value. This is available if the final result is more valuable in comparison with the total price of the individual stages, the implementation of which allowed to achieve this result. In order to understand this, you should find out what the net present value is and how it is calculated.
What is the present value?
Current or present value is calculated based on the concept of money in time. It is an indicator of the potential of funds allocated to generate income. It allows you to understand how much the amount that is currently available will cost in the future. Carrying out the appropriate calculation is of great importance, since payments made in a different period can only be compared after they have been reduced to one time period.
The present value is formed as a result of reduction to the initial period of future receipts and expenses of funds. It depends on how the interest is calculated. For this, simple or compound interest, as well as annuity.
What is net present value?
The net present value of NPV is the difference between the market price of a particular project and the cost of its implementation. The abbreviation used to refer to it stands for Net Present Value.
Thus, the concept can also be defined as a measure of the added value of the project, which will be obtained as a result of its financing at the initial stage. The main task is to implement projects that have a positive indicator of net present value. However, to begin with, one should learn to define it, which will help to make the most profitable investments.
NPV basic rule
You should familiarize yourself with the basic rule that the net present value of investments has. It lies in the fact that the value of the indicator must be positive for the consideration of the project. It should be rejected if a negative value is received.
It is worth noting that the calculated value is rarely zero. However, upon receiving such a value, it is also advisable for the investor to reject the project, since it will not make economic sense. This is due to the fact that the profit from the investment will not be received in the future.
Calculation accuracy
In the process of calculating NPV, it is worth remembering that the discount rate and revenue forecasts have a significant impact on current value. The end result may be errors. This is due to the fact that a person cannot make a forecast for future profit with absolute accuracy. Therefore, the obtained indicator is only an assumption. He is not immune to fluctuations in different directions.
Of course, the investor needs to know what profit will be received by him before investing. To ensure that deviations are minimal, the most accurate methods should be used to determine efficiencies in combination with net present value. The common use of various methods will help to understand whether investments in a particular project will be beneficial.If the investor is confident in the correctness of his calculations, you can make a decision that will be reliable.
Calculation formula
When searching for programs to determine the net present value, you may come across the concept of "Net present value", which has a similar definition. It can be calculated using MS EXCEL, where it is found under the abbreviation NPV.
The following data is used in the applied formula:
- CFn - the amount of money for the period n;
- N is the number of periods;
- i is the discount rate, which is calculated from the annual interest rate
In addition, cash flow for a certain period can be zero, which is equivalent to its complete absence. When determining income, the amount of money is recorded with a "+" sign, for expenses - with a "-" sign.
As a result, the calculation of net present value leads to the possibility of evaluating the effectiveness of investments. If NPV> 0, the investment will pay off.
Application restrictions
Trying to determine what the net present value of NPV will be, using the proposed methodology, one should pay attention to some conditions and limitations.
First of all, the assumption is made that the indicators of the investment project during its implementation will be stable. However, the probability of this may approach zero, since a large number of factors affect the amount of cash flows. After a certain time, the cost of capital allocated for financing may change. It should be noted that in the future the obtained indicators may change significantly.
An equally important point is the choice of the discount rate. As it can be used the cost of capital raised for investment. Depending on the risk factor, the discount rate may be adjusted. A premium is added to it, so the net present value is reduced. This practice is not always justified.
The use of a risk premium means that the investor primarily considers only the loss. He may by mistake reject a profitable project. The discount rate may also be the return on alternative investments. For example, if the capital used for investing is invested in another business at a rate of 9%, it can be taken as the discount rate.
Advantages of using the technique
The calculation of net present value has the following advantages:
- the indicator takes into account the discount factor;
- when making a decision, clear criteria are used;
- the ability to use when calculating project risks.
However, it is worth considering that this method has not only advantages.
Disadvantages of using the technique
The net present value of the investment project has the following negative qualities:
- In some situations, it is quite problematic to correctly calculate the discount rate. This most often applies to multidisciplinary projects.
- Despite the fact that cash flows are predicted, it is impossible to calculate the probability of the outcome of an event using the formula. The applied coefficient can take into account inflation, but basically it is the rate of profit laid down in the settlement project.
After a detailed familiarization with the concept of “net present value” and the calculation procedure, the investor can conclude whether it is worth using the methodology in question. To determine the effectiveness of investments, it is desirable to supplement it with other similar methods, which will allow you to get the most accurate result. However, there is no absolute probability that it will correspond to the actual receipt of profit or loss.
