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Basics of Net Present Value

Thursday, June 29, 2006
The basic idea of the net present value is that $100 now is better than $100 in 5 years because over 5 years that $100 would have a chance to grow. Now knowing that $100 now is better than $100 later is good, but often we need a way to quantify the differences in the two cash flows. To do this, we discount the cash flow with an acceptable interest rate. Net present value, or NPV, is the sum of all the discounted cash flows associated with a project.

So the net present value of $100 now is still $100 because it has no interest. However, lets say the acceptable rate of return is 10%, the discounted cash flow for $100 at 10% is as follows:

$100/(1+.1)^5=62.091

With this you can see that we would obviously take the $100 now. However, if you were offered $50 now, or $100 in 5 years, then the $100 in 5 years would be a better choice. The idea of NPV is to discount an initial investment, and then the resulting payment. If the sum of the two is positive, then the investment is a good idea, if it is negative, more money can be made elsewhere.

People often don't just hand out money of course. There are a few practical uses of NPV that I think you will like. I use it when evaluating advertising campaigns. After I have evaluated a PPC campaign I decide how much money I want to budget for the next month, and how much it will bring in. Then I figure out when the project will need to grow again and try to model that in with individual discounted cash flows. That way the value of the campaign, or the initial investment, is known from the start.

It can also be used from a publisher point of view, where you are considering building a site. The problem with that of course is that typically the impact of building a site has on your financials is pretty unknown. After the site has been around for a while, it could be used to predict the results of buying a batch of content or something of that nature.

Obviously Net Present Value is a valuable tool for evaluating investment projects. Sometimes investments are not made in monetary forms, such as building a site when you are not necessarily an employee. This time can be factored in by using the amount you would have made on the next best project. I will talk more about determining a discount rate on the next post.

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