Net Present Value (NPV) explained

Summary

This video explains the concept of Net Present Value (NPV) in a clear and simple way. It begins by defining the related concepts of Present Value (PV) and Future Value (FV), showing how money's value changes over time. Through practical examples, it demonstrates how to calculate PV and FV for different periods and investments. The video then walks through the process of calculating NPV, using an example project to show how future cash flows are translated into today's money. The core takeaway is that NPV helps assess the true value of a project by factoring in the time value of money.

Takeaways

• 😀 Present Value and Future Value are related concepts that help in understanding how money changes over time.
• 😀 Future Value is calculated by multiplying the present value by (1 + rate of return).
• 😀 Present Value is calculated by dividing the future value by (1 + rate of return).
• 😀 The formula for Future Value is: Present Value * (1 + rate of return) ^ number of years.
• 😀 The formula for Present Value is: Future Value / (1 + rate of return) ^ number of years.
• 😀 To calculate Future Value over multiple years, multiply the present value by (1 + rate of return) repeatedly for each year.
• 😀 To calculate Present Value over multiple years, divide the future value by (1 + rate of return) repeatedly for each year.
• 😀 Net Present Value (NPV) is the sum of present values of future cash flows minus the initial investment.
• 😀 NPV calculation involves translating future cash flows into today's equivalent values, considering the time value of money.
• 😀 A positive NPV indicates that the project is worth pursuing, as it creates value for the company.
• 😀 A negative NPV means the project does not create value and should be rejected.

Q & A

What is the main idea behind Net Present Value (NPV)?

The main idea behind NPV is that time is money. It takes the time value of money into account by translating future cash flows into today's value and comparing them with the initial investment.

What is the difference between Future Value and Present Value?

Future Value is the amount of money you will have in the future if you invest today, considering a certain rate of return. Present Value is the amount of money you need to invest today to achieve a specific amount in the future, considering that same rate of return.

How do you calculate Future Value for multiple years?

To calculate Future Value for multiple years, you multiply the present value by (1 + rate) raised to the power of the number of years. For example, if you invest $100 at a 20% return for two years, the calculation would be $100 × (1.2)^2 = $144.

How do you calculate Present Value for multiple years?

To calculate Present Value for multiple years, you divide the future value by (1 + rate) raised to the power of the number of years. For example, if you want $144 in two years at a 20% return, you calculate $144 ÷ (1.2)^2 = $100.

What is the Weighted Average Cost of Capital (WACC)?

The Weighted Average Cost of Capital (WACC) is the calculation of a company's cost of capital, weighted by the proportion of each category of capital, such as debt and equity. It reflects the cost of financing a project or investment.

What is the formula for calculating Present Value?

The formula for Present Value is: Present Value = Future Value ÷ (1 + rate)^years. This formula adjusts future cash flows to their equivalent value today.

How is Net Present Value (NPV) calculated?

To calculate NPV, you sum the present values of all future cash flows and subtract the initial investment. If the result is positive, the project is considered worthwhile.

What does the 'Net' in Net Present Value refer to?

The 'Net' in NPV refers to the subtraction of the initial investment from the total present value of future cash flows. It shows whether the investment creates value after considering the costs.

How do you determine if a project is worth pursuing using NPV?

If the Net Present Value of a project is positive, it indicates that the project is expected to create value, making it worth pursuing. If the NPV is negative, the project should be rejected.

Why is it important to consider the time value of money in project evaluation?

The time value of money is important because money today is worth more than the same amount in the future due to factors like inflation and opportunity cost. By adjusting future cash flows to present value, NPV provides a more accurate picture of a project's potential profitability.