|Interest Rate | Present Value |Net Present Value |

|Calculating the Net Present Value |

Making Investment Choices

In most cases businesses have alternatives in making investments.  In most cases the investments are dissimilar and cannot be easily compared.  As a result, the financial community has developed a method of analysis called discounted cash flow or Net Present Value as a technique for aiding in the decision process.

The essential ingredients to making these types of decisions are:

1. A solid project plan which defines the planned cash outlays, along with contingencies/risks

2. A defined benefit stream showing values added to the business, usually or hopefully approved by the business unit that will receive the benefit, and

3. A financial decision model.  The model defines the discount or hurdle rate that will be used to evaluate all projects in the company.   If a project is more risky than others, a common approach is to add several points to the discount rate.

The Analysis is simple and straightforward (after you have been through several times.

Interest Rate Examples

At the heart of the analysis is the concept of interest rates in reverse.  we usually think of interest as something paid on an investment and compounding over time.  The formula for this is:

Amount = Principle*(1+rate)**Term  where Term is the number of months or years the investment will be generating interest.  The following chart shows the value of a $10,000 investment at the end of each of 6 years for three different rates.

The chart shows what you would expect, the original principle grows over time, which is why you make the investment.

Present Value Examples

Present Value Calculations are the reverse of the interest calculation.   These computations determine the amount to be invested today to return a specific amount at some future time.  The table below shows the current value of a $10,000 payment made at the end of a given year, and the current amount needed to be invested at a given rate to get $10,000.

The Current Value is sometimes called the Present Value.

Net Present Value Examples

With an accurate set of cost and benefit estimates, you can use the financial model to calculate the Net Present Value (the current worth of the project) netting costs and benefits.  These are laid out over time, as known.  From this forecast of cash flows, you can calculate the Net Present Value of the Project.  Usually you are in competition for funds with other components of the business.  This NPV approach has the advantage of removing the dissimilarities and reducing the comparison to financial data.  This may be overly simplistic in some cases and we need to be aware of this so we are not trapped into a "numbers win" situation where it is not appropriate.

The following (and last) chart shows the Net Present Value of the stream of $10,000 annual payments, along with the contribution from each year.  Please note that as you go farther out, the Current value decreases, and decreases faster with a higher interest rate.  This is exactly the reveres of the Interest chart above.

Calculating the Net Present Value of a Stream of Cash Flows

The process is straightforward, and even simpler if you use Excel.  You take the cash flows and fill in row two of the following matrix.  I will use arbitrary examples:

  The Discount, at 10%, is the factor to be applied to the gross value of the cash flow to equate it to the value today.  That is If you invest $.91today, at the end of one year you will have $1.00.  Similarly $.56 invested today will generate $1 in 6 years.

Using the discount, we multiply the cash flow in a given year to determine present value.  The total stream of the present values is the Net Present Value for the proposition.  Note that the $52,000  NPV is not easily related to any of the gross cash flows.  Also note that the effect of inflows further out in time is diminished. 

This is one reason why projects with long payoffs do not receive the attention they might otherwise receive.  One possibility is to structure these kinds of projects so that they are delivered in phases and the benefits streams start earlier.