Just thought of writing my understanding as a blog. Would be delighted if someone found this useful.
Present Value or PV is the value of the investment in today's terms. It is the value of future cash flows of the project in today's dollars.
This is a discounted cash flow technique and one of the Benefit Measurement Methods under the Project Selection Methods tool and technique which is used for creating a Project Charter.
Ouch, that was quite long. To repeat, the Project Charter creation process uses a tool and technique called Project Selection Methods. One of the techniques under the Project Selection Method is Discounted Cash Flow which calculates Present Value.
The formula for calculating a Present Value is
PV = FV/(1 + i)nwhere
PV - Present Value to be calculated
FV - Expected Future Cash inflow
i - Notional Interest or Expected Rate of Interest
Net Present Value:
This is another interesting twist to calculate the Net future income/future cash inflow of the project in today's dollars. There is no big difference or additional concept to remember here. This is just a sum of all the expected Present values subtracted by the investment. For example, if we assume that the following are the given values.
Invested Amount : $5,00,000
Income Expected (Future Value)- 1 Year : $200000
Income Expected (Future Value)- 2 Year : $300000
Income Expected (Future Value)- 3 Year : $100000
Rate of Interest : 5% per annum
Now calculate the Present value for every year with the Present Value (PV) formula.
|1||$200000||2,00,000/(1 + .05)||190476.2|
|2||$300000||3,00,000/(1 + .05)2||272108.84|
|3||$100000||3,00,000/(1 + .05)3||86383.76|
Total NPV (For 3 years) = 5,48,968.8
NPV for the project = Total NPV (For 3 years) - Original Investment = 5,48,968.8 - $5,00,000
So the final NPV is 48,968.8.
And the formula for calculating the Net Present Value is,
NPV = PV1 + PV2+ PV3 .. + PVn - Invested Amount
According to the theory of NPV if the calculation of NPV yields a positive value or more than zero, then it is expected to make profit. It can get a go recommendation if all other factors look good. Additional points to remember are like,
- NPV assumes that the cash flows are re-invested at the cost of capital. ie, the same interest rate
- If NPV calculation is greater than zero accept the project. Otherwise reject the project
- Another note is that projects with high returns early in the project are preferred over the ones with lower returns early in the project.