Net Present Value

Net Present Value is a method to estimate the current value of future cash flows. In its simplest form, Net Present Value applies a discount rate to a future cash flow number and the product is the Net Present Value.

The discount rate may have many components; Internal Rate of Return (IRR), Cost of Capital, Cost of Debt, Risk, and so on.

Let's consider a simple example. Suppose, ignoring Shakespeare's advice I lent $100.00 each to two friends of mine, due one year from today.

One friend calls up and asks me how much will I accept from him if he pays today. Because I am getting currenlty getting 5.27% on my invesments, and this fiend is almost risk free (he is conservative) I tell him I will accept $95.00. This $95.00 is the Net Present Value of the $100.00 owed to me. The discount rate I used was my IRR.

My other friend, a Wikipedia editing liberal also owes me $100.00 one year from now. Fearing he will contribute all his money to left wing candidates in the upcoming election, I call him and tell him I will clear of his debt if he gives me $90.00 today. My discount rate, now 10%, includes the original IRR but also an additional factor for risk.

Note then, that while the lender (me) and the product (money loan) remained the same, the discount factor, hence present value, can and will change.