net present value

Method of financial analysis based on the concept that money has a time value. This means that an amount of money receivable today is worth more than the same amount receivable tomorrow, because of the opportunity to earn interest on the amount received today or the cost of interest on borrowed capital. The difference between the present value of the receipts and the present value of the expenditures is net present value. The best choice of financial alternatives is the one with the highest net present value.

Net present value calculations can be mathematically complex, involving different timing in receipts, for example sums realized on sale for salvage at the end of an item's useful life of the alternative choices, as well as different and changing rates of interest. Nevertheless any net present value analysis should involve five rudimentary stages: select the discount rate; identify the costs/benefits to be considered in analysis; establish the timing of the costs/benefits; calculate net present value of each alternative; select the alternative with the best net present value.

For example, if there was the opportunity to purchase a car, but the entire amount had to be borrowed, and there were two choices: 1) cash required on sale £11,000, or 2) interest free loan for one year, the best option using net present value would be option 2, because a year's interest is saved. However, the offer might be: 1) cash on sale £10,000, or 2) interest free loan for one year. To compare these two offers the present value of money is used. If the interest is 10% the £10,000 would earn £1,000 in interest in a year. Therefore we can say the present value of £11,000 one year from now with an interest of 10% is £10,000. Therefore the two options are equivalent.