Net Present Value NPV

Net Present Value is often abbreviated to its acronym NPV. It is a measure of the value of a dollar today compared to the same dollar in the future. In order to make this comparison we need to take into account inflation and any returns (such as interest) that may be realized by that dollar if it were to be invested.

The easiest way to calculate the NPV is to use a spreadsheet such as Microsoft Excel which has a formula called =NPV() which will do the calculation for you.

The following image is from an example done in Excel 2007. The excel spreadsheet that was used can be downloaded below.

[file]014bad51-6357-492d-a527-898290312fae[/file]

[file]7af60a24-3b79-4c6e-a2cf-02742dda6487[/file]

In the example above we are calculating the present day value of buying a business that will generate a cash flow of $1,000 for each of the next 6 years. Our assumed interest rate is 4.5%. Using the Net Present Value formula in Excel shown in cell B6 we can see that the NPV of the business is $5,157.87 even though it will generate $6,000 over the life of the business.

If our estimate of inflation of 4.5% over the next 6 years is accurate then we should not pay more than the NPV for the business. If the owner were to sell it to us at any price below $5,157.87 then it would be worth buying.