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What Are the Advantages of Net Present Value?

Jim B.
Jim B.

There are many advantages of Net Present Value, or NPV, all of which relate to the calculation's accuracy in determining what a future sum of money is actually worth in present conditions. The measurement is based upon the theory of the time value of money, which indicates that a specific sum of money now is worth more than that same sum is worth in the future. Inflation rates and the rates at which invested money can grow in the future combine to form a discount rate that devalues future money. Since the calculation takes the discount rate into account, one of the chief advantages of net present value is its utility in making key financial decisions.

Business decisions are difficult to make on any scale, from people deciding upon whether to make a key purchase to businesses deciding if they should go ahead with a costly new project. It can be foolish to make these decisions without first considering the affect that time has on money. For that reason, a calculation that honors the relationship between time and money, which is one of the key advantages of net present value, is crucial.

Man climbing a rope
Man climbing a rope

Net present value is a complicated calculation, best handled by calculators provided by websites and financial professionals which require simple data entry. It requires the knowledge of the potential future cash flows that will be generated by the investment being measured. In addition, the discount rate, which is the percentage that a sum of money in the future must be reduced to render its present value, must be decided.

Another one of the advantages of net present value is that the entity making the decision can decide upon the discount rate. By personalizing the rate, the calculation of NPV more accurately represents the circumstances of the situation. For example, an individual on a tight budget might decide upon a cautious discount rate to determine the net present value of a current investment. By contrast, a business with large coffers might be able to take on more risk in return for potentially greater rewards.

Whatever the case, perhaps the most crucial of the advantages of net present value is its usefulness in making a business decision. Once the NPV is calculated, the entity making the decision simply has to compare the current cost to the NPV. For example, a business that has the opportunity to buy a new factory for $100,000 US Dollars (USD) should only go forward with the purchase if the NPV of the future cash flows is greater than $100,000 USD. Otherwise, the business would be better served investing the money elsewhere.

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