Net Present Value (NPV)
Often you will be required to compare the value of money today with the value of the same money at some date in the future. We refer to this analysis as calculating the net present value (NPV). Intuitively you understand that a dollar earned today but not received until sometime in the future will most likely have less spending power at that future date. This is particularly true if you are waiting for American dollars earned today and payable tomorrow!
We refer to the ‘discount rate‘ as the percentage used to calculate the NPV to reflect the time value of money. That is how many goods and services will the money owed today buy when it is received at a future date. To calculate this figure, we discount the value of the money owed. For example, if you are owed $20,000 but agree to defer receipt for 10 years with a 5% discount rate; in today’s dollars, the true spending power of that $20,000 10 years from now will be $12,278.30! You will have lost the opportunity to invest or use the money today by agreeing to defer its receipt. This loss is called an opportunity cost. From this example, you can certainly see why it is important that your financial analysis consider the NPV of money.
The discount rate (percentage) used to determine the NPV is generally based on historical data such as the Consumer Price Index (CPI)[1]. You determine what you believe to be a suitable discount rate by considering historic inflation rates and your sense of anticipated inflation rates. In this case, the forecasted inflation rates over the next 10 years. Given this data, you can establish an appropriate discount rate.
Similar to mortgage amortization tables, there are tables available to assist you in computing NPV. You’ll find one on the companion website at www.power.nelson.com. If you wish to calculate NPV without using a prepared table, the formula is FV= P (1+i) n, where FV = the future value of one dollar; P = principal; i= interest rate per year; and n = number of years.
[1] The consumer price index is one of the most commonly referred to as economic indicators. Economists use it to evaluate the success or failure of inflation control by government and public policy. Government and businesses rely on the CPI to forecast the future value of money, set salaries, as well as for a number of other purposes. However, the CPI was criticized on a number of fronts. One criticism is that the CPI does not include the cost of housing, an oil-based product, or healthcare costs. I think most of us would agree that a consumer price index that does not include these types of items does not reflect the reality of consumers’ major expenditures.
