Net Present Value

As we all know, the value of a dollar today is not the same as a value of a dollar tomorrow. Inflation will consistently erode the value of money over time. When calculating the value of an investment, one must consider that the value of money will change over time as well as the opportunity cost of capital or cash on hand that can be invested elsewhere. To account for this, one can use Net Present Value (NPV) calculations.

Consider a product or service with an inception to end-of-life of four years. Assuming it costs $500K in development in the first year, and $100K to maintain over the next three years, one may calculate the total costs to be $800K over the four years. Assuming the benefits are $0K in the first year and $500K per year for the final three years, one may calculate the benefits as $1.5M for a total profit of $700K.

However, what if you had the cash on hand, invest it elsewhere, and account for inflation? There is an opportunity cost associated with that option. The example below shows the Net Present Value calculations for the same project. It applies a Discount Rate, which is the opportunity cost of capital, to the calculation. The Discount Rate is normally provided by your accounting department. The discount factor compound subtracts the discount rate each year. In the example below, 7% is subtracted each year starting after the first complete year.

The example above gives a profit of $549,600.

As previously mentioned, if you performed a straight calculation, you would see a profit of $700K. However, after calculating the opportunity costs with Net Present Value, the actual profit is only $549,600. As you can see, the value of a dollar changes over time and can make a significant impact into profit forecasting.

Therefore, when determining the business case for a profit or service, always use Net Present Value calculations to get a more accurate profit value for comparison against other opportunities.





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