The Net Present Value (NPV) is an investment criterion that consists of updating the receipts and payments of a project or investment to know how much is going to be gained or lost with that investment. Also known as Net Present Value (NAV), Net Present Value, or Net Present Value (NPV).
To do this, it brings all the cash flows to the present moment, discounting them at a specific interest rate. The NPV will express a measure of project profitability in absolute net terms, that is, in number of monetary units (euros, dollars, pesos, etc.).
Net Present Value (NPV) Formula
It is used for the valuation of different investment options. Since by calculating the NPV of different investments we will know with which of them we are going to obtain a greater profit.
F t are the money flows in each period t
I 0 is the investment made at the initial moment (t = 0)
n is the number of time periods
k is the discount rate or interest rate required on the investment
The NPV serves to generate two types of decisions: first, to see if the investments are feasible and second, to see which investment is better than another in absolute terms. The decision criteria will be the following:
- GO> 0: The updated value of future investment collections and payments, at the chosen discount rate, will generate benefits.
- VAN = 0:The investment project will not generate benefits or losses, being its implementation, in principle, indifferent.
- GO <0:The investment project will generate losses, so it must be rejected.
Advantages and disadvantages of VAN
Like any economic metric and indicator, the net present value has some advantages and disadvantages that are presented below:
Net Present Value Advantages
The NPV has several advantages when evaluating investment projects, mainly that it is an easy method to calculate and at the same time it provides useful predictions about the effects of investment projects on the value of the company . Furthermore, it has the advantage of taking into account the different maturities of net cash flows.
Disadvantages of net present value
But despite its advantages, it also has some drawbacks such as the difficulty of specifying a discount rate and the hypothesis of reinvestment of net cash flows (it is implicitly assumed that positive net cash flows are immediately reinvested at a rate that coincides with the discount rate, and that negative net cash flows are financed with resources whose cost is also the discount rate.
You may also be interested in the relationship between VAN and TIR.
Suppose that they offer us an investment project in which we have to invest 5,000 euros and promise us that after that investment we will receive 1,000 euros the first year, 2,000 euros the second year, 1,500 euros the third year and 3,000 euros the fourth year.
So the cash flows would be -5000/1000/2000/2500/3000
Assuming that the money discount rate is 3% per year, what will be the NPV of the investment?
For this we use the NPV formula:
The net present value of the investment at this time is 1894.24 euros. As it is positive, it is convenient that we make the investment.