Many investors had to lose sleep and appetite in trying to determine the most effective way to minimize investment risks and maximize profits. However, it is only necessary to increase economic literacy. Net present value will allow a much more objective look at financial issues. But what is it?
Cash
Before talking about such a question as net present value, it is first necessary to understand the related concepts. Positive incomes (cash flows) represent the funds that go into the business (interest received, sales, revenue from stocks, bonds, futures, and so on). Negative flow (i.e. expenses) represents funds that flow from the company's budget (salaries, purchases, taxes). Net present value (absolute net financial flow), in fact, represents the difference between negative and positive flows. It is this value that answers the most important and most exciting question of any business: "How much money remains at the box office?" To ensure the dynamic development of the business, the right decisions regarding the direction of long-term investments are necessary.
Investment Questions
Net present value is directly related not only to mathematical calculations, but also to the ratio of investment. Moreover, an understanding of this issue is not as simple as it seems, and is based primarily on the psychological factor. Before investing in any project, you must first ask yourself a series of questions:
- Will the new project turn out to be profitable and when?
- Maybe you should invest in another project?
The net present value of investments should be considered in the context of other issues, for example, about negative and positive flows of the project and their impact on the initial investment.
Asset movement
Financial flow is an ongoing process. The assets of the enterprise are regarded as the use of funds, and capital and liabilities as sources. The final product in this case is a combination of fixed assets, labor, raw material costs, which are ultimately paid in cash. Net present value is considered precisely the movement of financial flows.
What is NPV?
Many people who are interested in economics, finance, investing and business have come across this abbreviation. What does she mean? NPV stands for NET PRESENT VALUE, and translates as net present value. This is calculated by summing up the income that the company will bring during operation, and the cost of the project. Then the amount of income is deducted from the amount of expenses. If as a result of all calculations the value is positive, then the project is considered as profitable. It can be concluded that net present value is an indicator of whether the project will generate revenue or not. All future income and expenses are discounted at the corresponding interest rates.
Features of calculating net present value
Net present value is the determination of whether a project is worth more than the costs spent on it. This value indicator is estimated with the calculation of the price of cash flows generated by the project. It is necessary to take into account the requirements of investors and the fact that these flows can become objects of trading on stock exchanges.
Discounting
The calculation of the net present value is carried out taking into account the discounting of cash flows at rates equal to opportunity costs when investing. That is, the expected rate of return on securities is equated with the same risk as the project in question. In developed stock markets, assets that are absolutely identical in terms of risk level are evaluated in such a way that the same rate of return is formed according to them. The price at which investors participating in financing this project expect to receive a rate of return on their investments is obtained precisely by discounting cash flows at a rate equivalent to opportunity costs.
Net present value of the project and its properties
There are several important properties of this project appraisal method. Net present value makes it possible to evaluate investments taking into account the general criterion of maximizing value that is at the disposal of investors and shareholders. This criterion obeys financial and currency transactions both in raising funds and capital, and in their allocation. This method focuses on cash income, which is reflected in the proceeds to the bank account, while neglecting the accounting income that is reflected in the financial statements. It is also necessary to remember that net present value uses the opportunity cost of financial resources for investment. Another important property is the submission to the principles of additivity. This means that it is possible to consider all projects both in total and individually, and the sum of all components will be equal to the cost of the overall project.
Fair value indicator
Net present value depends on a measure of current value (PV). This term refers to the value of future cash receipts, which refers to the present moment discounting. The calculation of the net present value usually includes the calculation of the present value indicator. You can find this value using a simple formula that describes the following financial transaction: placement of funds, payment, repayment and lump-sum repayment:
PV = FV / (1 + r).
where r is the interest rate, which is the payment for money taken on credit;
PV is the amount of funds that are intended to be placed on a paid, urgent, repayable basis;
FV is the amount needed to repay the loan, which includes the original amount of the debt, as well as interest.
Calculation of net present value
From the indicator of current value, we can proceed to the calculation of NPV. As mentioned above, net present value is the difference between discounted future cash flows and the total investment (C).
NPV = FV * 1 / (1 + r) -C
where FV is the sum of all future project income;
r is the rate of return;
C is the total amount of all investments.