Time is money. The sooner you receive cash from an investment or project, the more it's worth. That's the main principle behind the concept of net present value, which discounts future cash flows back to current dollars based on their timing. As an alternative to the regular calculation, analysts can also use the nominal net present value method.
Net Present Value Basics
Net present value is the sum of all project cash outflows and inflows, each being discounted back to present value. To calculate net present value, you need to know the initial investment in a project, how much cash you expect it to produce and at what intervals, and the required rate of return for capital. If a project's net present value is positive, that means it generates more than the required rate of return for capital investments and management should go forward with the project. If it's negative, management should reject the project.
Present Value in Action
Net present value is the sum of all discounted cash inflows and outflows. A discounted cash flow is equal to the cash flow divided by one plus the interest rate to the power of the period the cash flow occurs. The dollar value of the initial project cash outlay is a negative number already at present value. For example, say a project costs $500,000, the required rate of return is 5 percent, and it will generate $750,000 in years one or two. The discounted cash flow for year one is $750,000 divided by 1.05 to the power of one, or $714,285. The discounted cash flow for year two is $750,000 divided by 1.05 squared, or $680,272. The net present value is $680,272 plus $714,285 minus $500,000, or $894,557.
Only Negative Cash Flows
If a project only has negative cash flows, it will have a negative present value. Still, calculating the net present value discounts the cost back to today's dollars. To calculate net present value with only negative cash flows, subtract all numbers instead of adding them. For example, say that a project requires an initial cost outlay of $500,000, the required rate of return is 5 percent and it will require additional cost outlays of $750,000 in years one or two. The net present value is negative $500,000 minus $680,272 minus $714,285, or negative $1,894,557.
Nominal Net Present Value
In the standard net present value calculation, the discount rate includes the effects of inflation. As an alternative, you can calculate net present value by converting the real cash flows to nominal cash flows and use a nominal discount rate. Both methods yield the same final number. Under nominal net present value, the cash flows are discounted to account for inflation, then discounted again with the present value factor of the nominal discount rate. For example, say that a project will have positive cash flows of $750,000 in year one, inflation is 2 percent and the corresponding nominal discount rate factor is 0.9804 percent. The inflation-adjusted cash flow is $750,000 divided by 1.02, or $735,294. The nominal-rate adjusted cash flow is $735,294 divided by 0.9804, or $750,000