The net present value — determine the current value of a future payout
What is Net Present Value (NPV)? - The definition
The Net Present Value (NPV) describes the current value of a future payout. Die net present value (NPV) method, Also known as the net present value method, is an instrument of dynamic investment appraisal and enables investors to calculate the financial value of an investment. The aim of this method is to discount the value of future cash flows to the present time and to decide whether an investment — such as in real estate, securities or machinery — is profitable. A positive net present value shows that the investment is worthwhile, as the return exceeds the initial investment amount and the fixed interest rate.
How is NPV calculated?
The calculation of the net present value is based on discounting all future cash flows, i.e. the expected deposits and withdrawals. The following factors are required for this:
- Investment amount: The costs of the investment.
- Cash flows - deposits and withdrawals: Cash flows that are expected from the investment.
- discount rate / Capitalization rate: This interest rate, also known as a discount interest rate, meets the return expectations of an alternative investment.
The calculation formula is:
NPV = present value of disbursements — investment amount
example: Ms. Studer plans to invest CHF 800,000 in condominium property in St. Gallen, which she would like to sell after four years for CHF 840,000. If your bank offers an interest rate of 2.5% for alternative investments, it uses this as a discount rate.
The calculation results in:
- Present value of disbursements = 840,000 CHF/(1 + 0.025) ^4 = 760.998 CHF
- Net present value = CHF 800,000 — CHF 760,998 = - CHF 39,002
The negative result of - CHF 39,002 shows that the investment is not worthwhile. Ms. Studer should invest in her bank's alternative investment rather than in real estate.
Interpreting NPV results
The NPV method provides investors with three possible scenarios:
- NPV is positive: The investment exceeds the target interest rate and the measure is profitable.
- NPV is zero: The return is exactly in line with the target interest rate. Further consideration is needed.
- NPV is negative: The investment does not meet the return requirement and is therefore less attractive than alternatives.
The influence of the discount rate is important, as even small fluctuations can change the interpretation of results. This is particularly relevant because assumptions must often be made that may not exactly correspond to reality.
NPV: Pros and Cons
The NPV method is popular because it:
- One simple basis for decision-making offers: The NPV shows directly whether an investment makes economic sense.
- temporal values taken into account: Future cash flows are comparable as a result of discounting.
However, it also has limitations:
- Unrealistic assumptions: The method requires equal debit and credit interest and neglects tax aspects.
- Dependence on capitalization rate: Varying interest rates can lead to incorrect results.
In summary, the net present value method is a useful tool for Assessment of profitability, but it is recommended to use other indicators to help.
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