Net Present ValueNet present value, often abbreviated as NPV, is one of the most helpful and fundamental tools available for financial decision making. While it is used heavily in the world of corporate finance, it can also be implemented for making decisions about everyday purchases and investments. Net present value, simply put, gives you the current value of a series of cash flows (both ingoing and outgoing). Calculating the NPV for a particular project or investment will yield a dollar amount, and this amount corresponds to the worthiness of the project. Fortunately, you can calculate NPV using nothing but a pencil, a sheet of paper, and a simple formula.1

Identify the project or investment you will be analyzing.For example, imagine you operate a small lemonade stand. You are considering buying an electric juicer for your business, rather than continuing to juice the lemons by hand. The decision you are interested in is whether or not the electric juicer is a profitable investment.

2Determine the expected cash flows associated with the project or investment. Continuing with the example of the lemonade stand, assume that the electric juicer would cost $100 (although these numbers will work equally well expressed in other currencies). You expect that implementing the juicer will bring in an additional $50 the first year, $40 the second year, and $30 the third year. Perhaps this is additional revenue generated or money saved in wages through increased juicing efficiency. After 3 years, you expect that the juicer will need to be discarded. So, your expected cash flows are: -$100 right now, +$50 in year 1, +$40 in year 2, and +$30 in year 3. It is a good idea to diagram these cash flows on a piece of paper.

3Determine the appropriate discount rate.This step is crucial to a good analysis, and also requires the most discretion. The discount rate is a number used to convert the values of the expected future cash flows into their present values. This is necessary because of what is known as the "time value of money." The value of money depends on when it is expected to be paid. For example, you should generally prefer to receive $100 right now than to receive $100 3 years from now. This is because you could have been investing that $100 over those 3 years, and at the end of that period, you would likely have more than your original $100. Therefore, $100 expected in 3 years is actually worth less than $100 right now. All future cash flows must be discounted back to their equivalent present values. Determining the appropriate discount rate requires some consideration; in corporate finance, a firm's weighted-average cost of capital is often used. In the lemonade stand example, you might decide that if you didn't purchase the juicer, you would probably invest the money in the stock market, where you feel confident you could earn 4% annually on your money. So, 4% is the appropriate discount rate.

4

Discount all the cash flows.This is done using a simple formula: P / (1 + i)^t, where P is the amount of the cash flow, i is the discount rate, and t represents time. Cash flows that occur immediately do not need to be discounted, as they are already expressed as present value. Using a 4% discount rate, the discounted cash flows from the lemonade stand example would be:

5

Add all of your discounted cash flows together to get the total NPV for the project.For the lemonade stand example, the final summation would be:

6

Determine whether or not to accept the project or investment.If the NPV for the project is a positive number, then the project will be profitable beyond your required rate of return, and you should accept the project. If the NPV is negative, your money is better invested elsewhere, and the project should be rejected. In the lemonade stand example, the NPV is $11.71. Does this mean that the electric juicer only made you $11.71? No! This means that the juicer made you the required profit of 4% annually, and made you an additional $11.71 on top of that. The juicer project is profitable, and should be pursued.