Everyone knows that the money you have in hand now is more valuable than the money you collect later on. This statement itself shows the great importance of net present value. That’s because you may use it to operate a business, purchase something now and sell it later for more money, or just put it in the bank and collect interest to generate more money. Future money is also less valuable because inflation decreases the buying power. It is called the time value of money, but how do you compare the value of money now with the value of money in the future?
Please read our blog to learn more about the net present value and the importance of net present value.
What Is Net Present Value?
The difference between cash inflows’ current value and withdrawals over time is known as net present value. It’s a method of calculating your return on investment, for a project and its expenditures. It is a capital budgeting tool to analyze a project’s profitability and investment.
Company ABC Ltd wanted to know the net present value of their cash flow if they invested 1,00,000 today. And their initial investment in the project is 80,000 for the three years, and they are expecting the rate of return is 10% yearly.
|5||Rate of return||10%|
NPV = cash flow/(1-i)^t – initial investment
What Is The Importance Of Net Present Value?
Optimum utilization of money:
Net present value is helpful in the optimum utilization of money. With the help of net present value, you can avoid unnecessary expenses. Suppose you have $2,00,000. You have many ways to spend your money; you can also save some, invest, etc. But net present value helps you make decisions for optimum money utilization.
Also read: Fundamentals of finance
Better investment decision:
It is very crucial to know the importance of net present value because it helps make better investment decisions. You have lots of ways to invest your money, but you can find the best alternative with the help of net present value.
In the context of the present conditions, investments are both significant and useful. Investment decisions’ importance has increased due to the following factors.
- Making retirement plans
- Interest rate
- high inflation rate
- Increase in tax rate
A high ROI means the investment’s gains compare favorably to its cost. As a performance measure, ROI is used to evaluate an investment’s efficiency or to compare several different investments’ efficiencies. Everyone wants the maximum rate of return. Once you invest your money in the best way, you get the maximum rate of return.
Efficient cash management:
Efficient cash management is Reducing an excessive amount of cash on hand is part of cash management. Making good use of money. Maintaining a healthy cash position to cover both anticipated and unforeseen expenses. Net present value is an efficient way of cash management. It aids in preventing wasteful spending.
Critical analysis is the in-depth analysis and evaluation of thoughts or works. We all know that net present value is very critical, but this analysis gives you many future benefits.
Scope of expansion:
When you get a maximum rate of return, you have lots of scope for expansion. Suppose you have $2,00,000 and you invest your money in gold. After a long time, you receive lots of returns, and Then you invest more and more. Net present value has lots of scope for expansion.
Case study: net present value
I remember my childhood when I was a school student. I used to get a samosa at 5$, but now the price is increasing. These days people generally get it for around $15, so as you can see, samosas are the same, their size is also the same, but its price has changed. This variation is nothing but a time value of money as you can see, over the years, the time value of many changes.
Time value of money divided into two categories
|Future value||Present value|
If today you invest $1,00,000 and the rate of return is 10%, now tell me the value of 1.00,000 after one year. I know you can easily answer this question. The value of 100,000 will be 100,000*(1-10%)= 1,10,000
You can also calculate the same value after two, three, four, and any number of years.
Present value is the opposite of future value. So, in this case, we are trying to figure out how much we should invest today to get 1,10,000 one year from now. Assuming its rate of return is 10%. We already did this above. We need to invest 1,00,000, but how we get that, the formula is simple. You have to divide that amount you are getting after one year 1,10,000/(1-10%)^1= 1,00,000, then we get the amount we have to invest today.
I hope you got the difference between the future value and the present value formula.
After reading this blog on the importance of net present value, I hope you understand it and its importance. In the end, we see a case study of net present value, and we learn the time value of money, future value and present value of money and how to calculate it. I hope this blog is helpful for you; thanks for reading.