ACCOUNTANTS AND INVESTORS ALIKE MUST UNDERSTAND THAT ACCOUNTING NUMBERS ARE THE BEGINNING, AND NOT THE END OF BUSINESS VALUATION    – Warren Buffet

Joe Knight (Partner and Senior Consultant with the Business Literacy Institute, a highly regarded finance and business literacy keynote speaker, trainer, and published author) writes in his book, Financial Intelligence writes “any investment that passes the NET PRESENT VALUE test will increase shareholder value, and any investment that fails would (if carried out anyway), actually hurt the company and its shareholders.”

For those who believe in and are convinced of Time Value of Money, (The money you have in your hands now is more valuable than money you collect later on., well obviously we could have made use of the more money in hands today for running a business, buying something now and selling it later on, investing in projects that would give returns or simply putting it in the bank and earning interest.) needs to know how exactly do we compare the value of money now with the value of money in the future.

Net Present Value comes in here!

“Net present value is the present value of the cash flows at the required rate of return of your project compared to your initial investment,” says Knight. Joe Knight, co-author of Financial Intelligence: A Manager’s Guide to Knowing What the Numbers Really Mean.

NPV shows how much money a project or investment will gain or lose in terms of today’s funds. A mere cash flow statement for future doesn’t closely reflect current cash flow of a project because of the impact of factors such as inflation and lost compound interest. Net Present Value incorporates it all.

By looking at all of the money you expect to make from the investment and translating those returns into today’s dollars, you can decide whether the project is worthwhile.

A higher Net Present Value is always considered when making investment decisions because it shows that an investment would be profitable. With a higher NPV, an investment would have a future cash stream that is higher than the amount of money that was invested in the project.

AS YOU MANAGE YOUR BUSINESS, YOU MIGHT NEED NET PRESENT VALUE FOR:

• Comparing projects and to decide which one to pursue.
• Valuation of Mergers and acquisitions.
• Evaluating new contracts, projects, investments and more.

In general, any time a company is using today’s money for future returns.         

 The discount rate will be company-specific as it’s related to how the company gets its funds. It’s the rate of return that the investors expect or the cost of borrowing money.

Remember: The calculation is based on several assumptions and estimates, which means there’s lots of room for error. You can mitigate the risks by double-checking your estimates and doing sensitivity analysis after you’ve done your initial calculation.

Things to note while you make the calculation:

• Initial investment – Quantifying price tag would be much easier when compared to estimates of employee time and cost and other resources.
• Discounting rate – The rate applied today might spike in the future years.
• Certainty on projected returns – Realistic certainty must be ensured as projections usually tend to be optimistic.

Net present value, often referred to as NPV, is the tool of choice for most financial analysts. There are two reasons for that. One, NPV considers the time value of money, translating future cash flows into today’s Rupees. Two, it provides a concrete number that managers can use to easily compare an initial outlay of cash against the present value of the return.