NET PRESENT VALUE

Net present value (NPV) is a method for selecting an alternative that offers the best investment. It accounts for the time value of money, as well as identifies which alternative provides a rate of return greater than that provided by a financial institution. If the resulting calculation is greater than that earned at a bank, then it is okay to make the investment.

The advantages of NPV are twofold. It provides the financial basis for deciding whether to make an investment. It also is a widely accepted method for making financial investments.

for Calculating the Net Present Value

• Calculate the cost of a proposal.
• Calculate its savings.
• Determine the interest rate.
• Determine the number of years that savings will occur (e.g., three-to-five years).
• Use the following formula for each proposal on computer software:
  
  
  
  
  • Example: The savings for any given year is $1,000; the interest rate is 5 percent (or .05). The cost of the proposal is $2,000. Calculate the net present value.
    
    
    
    
  • Note: A positive value suggests investing in the proposal. A negative value suggests investing it in a different place of higher return.