Net present value is the difference between an initial cost outlay and the present value of expected cash flow.
Step 1: Estimate the value of an investment Estimate the value of the investment of an initial cost outlay today and at one or more times in the future. The initial cost outlay is the cost of entering the project.
Step 2: Calculate the present value Calculate the present value of your investment over a period of time using the equation C1 divided by (1 plus r) plus Cn divided by (1 plus r)n where Ci is the cash flow in period 1, n is the number of periods, and r is the discount rate.
TIP: If the discount rate is 15 percent, and you are offered a series of cash flows over the next four years of $5,000, $4,000, $3,000, and $2,000 for an initial cost outlay of $10,000, the present value is $5,000 divided by (1.15) plus $4,000 divided by (1.15) 2 plus $3,000 divided by (1.15) 3 plus $2,000 divided by (1.15)4 equals $10,490.
Step 3: Calculate net present value Calculate the net present value by subtracting the initial investment from the computed present value.
TIP: The net present value is $10,490 minus $10,000 equals $490.
Step 4: Decide whether the investment makes sense A positive net present value means the investment is acceptable; a negative net present value means the investment is not a good idea.
FACT: People have been computing compound interest rates since the time of the Babylonians.