Key Difference – Present Value vs Net Present Value
Present value and net present value revolves around the same concept, and net present value can be interpreted as an extension of present value. Effects of inflation reduce the value of funds; thus the concept of present value is developed in order to make effective business decisions by taking the time value of money into consideration. The key difference between present value and net present value is that present value is today’ value of a cash flow in contrast with its future value whereas net present value is the difference between present value of future cash inflows and cash outflows.
CONTENTS
1. Overview and Key Difference
2. What is Present Value
3. What is Net Present Value
4. Side by Side Comparison – Present Value vs Net Present Value
5. Summary
What is Present Value?
Present value is the value of a cash flow at present in contrast to its future value had it been invested at compound interest. Simply, this calculates how much funds an investor will have at the end of a specific future period if the funds were invested at a particular interest rate (called ‘discounting factor/rate’) in today’s terms. Discounting factors can be easily acquired through the present value table that shows the discounting factor with correspondence to the number of years.
E.g. A lender gives $10,000 to a borrower who agrees to settle the entire amount at the end of 2 years with an interest rate of 10%. In today’s term, this amount is equal to,
$10,000* 0.826 (10% Discounting factor for 2 years) = $8,260
What is Net Present Value?
Net Present Value (NPV) is the difference between present value of future cash inflows and cash outflows. NPV is one of the most widely used investment appraisal techniques to evaluate the financial viability of capital projects. Here, all the future cash inflows and outflows will be discounted at the required rate of return from the project.
E.g. ANK Ltd is planning to make an investment in a new factory in order to increase production. Consider the following information.
- The investment project will span over a period of 4 years
- Initial investment is $12,500 which will be invested in Year 0 (today)
- The investment has a residual value of $2,000
- Cash inflows and outflows will happen from Year 1 to Year 4
- Tax @ 25% will be paid in arrears (tax for one year will be payable in the next year) on operating cash flows
- Cash flows will be discounted using a discount rate of 10%
The above project generates an NPV of -6,249.8, which means that if the project is carried out, it will generate a net cash flow of -6,249.8 in today’s terms. Since this is a loss in present value, undertaking this project is not beneficial for ANK Ltd.
Decision criteria for NPV is a standard one which states,
- Accept the project if it generates a positive NPV
- Reject the project if it generates a negative NPV
Figure 1: NPV is a useful criteria to select between two or more investment options when the company do not have resources to invest in all options
What is the difference between Present Value and Net Present Value?
Present Value vs Net Present Value
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| Present value is today’ value of a cash flow in contrast with its future value. | Net present value is the difference between present value of future cash inflows and cash outflows. |
| Cash Flows | |
| Present value can be calculated for a single cash flow. | Net present value calculates the net effect of cash inflows and outflows. |
| Use in Investment Appraisal | |
| The concept of present value is used in investment appraisal | Net present value is used as an investment appraisal technique. |
Summary – Present Value vs Net Present Value
The difference between present value and net present value is not a significant one and both are built on the same concept of evaluating a financial decision by taking into account the time value of money. The required rate of return from an investment should be clearly agreed upon by the management since the resulting NPV will vary when NPV is calculated for different discounting rates. While very useful, it should be noted that NPV is based on forecasted cash flows, which are difficult to predict in case where the investment take several years to complete.
References
1. “What is the difference between Present Value (PV) and Net Present Value (NPV)? | AccountingCoach.” AccountingCoach.com. N.p., n.d. Web. 03 Apr. 2017.
2. “Annualized Net Present Value (ANPV), Comparing Projects involving different lives.” Help for ACCA AND CIMA Studies (Also useful to B.COM, CA,ICWAI,CS, M.COM,M.B.A). N.p., n.d. Web. 03 Apr. 2017.
3. Picardo, CFA Elvis. “Discount Rate.” Investopedia. N.p., 23 Jan. 2014. Web. 03 Apr. 2017.
4. “Evaluating projects using NPV (net present value).” IPlanWare Project Management Blog RSS. N.p., n.d. Web. 03 Apr. 2017.
Image Courtesy:
1. “PDF3NPV” By AdamD – Own work (Public Domain) via Commons Wikimedia