Difference between revisions of "Net Present Value"
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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. | 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, estimated inflation and risk. | + | The discount rate may have many components; Internal Rate of Return (IRR), Cost of Capital, Cost of Debt, Risk, estimated [[inflation]] and risk. |
Suppose you lent $100.00 to Person A. It is to be repaid within one year. You would like a return of 5% on your money you expect inflation to be 2%, and your assessment of risk for this person leads you to add 1% to the discount rate. This means you would assign a discount rate of 8% to this loan. If this person approached you suggesting, I will give you $90.00 today to discharge my loan, you would counter that you needed at least $92.59. (92.59 x 1.08 = $100.00) | Suppose you lent $100.00 to Person A. It is to be repaid within one year. You would like a return of 5% on your money you expect inflation to be 2%, and your assessment of risk for this person leads you to add 1% to the discount rate. This means you would assign a discount rate of 8% to this loan. If this person approached you suggesting, I will give you $90.00 today to discharge my loan, you would counter that you needed at least $92.59. (92.59 x 1.08 = $100.00) | ||
| − | Usually a corporation will use a Weighted Average Cost of Capital as a discount rate when NPV is the appropriate method of evaluating an invesment or capital expenditure. | + | Usually a [[corporation]] will use a Weighted Average Cost of Capital as a discount rate when NPV is the appropriate method of evaluating an invesment or capital expenditure. |
[[Category:finance]] | [[Category:finance]] | ||
Revision as of 11:54, October 20, 2007
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, estimated inflation and risk.
Suppose you lent $100.00 to Person A. It is to be repaid within one year. You would like a return of 5% on your money you expect inflation to be 2%, and your assessment of risk for this person leads you to add 1% to the discount rate. This means you would assign a discount rate of 8% to this loan. If this person approached you suggesting, I will give you $90.00 today to discharge my loan, you would counter that you needed at least $92.59. (92.59 x 1.08 = $100.00)
Usually a corporation will use a Weighted Average Cost of Capital as a discount rate when NPV is the appropriate method of evaluating an invesment or capital expenditure.