# Net Present Value (NPV)

What is the Present Value?

To understand the implications of the Net Present Value rule, we must introduce the concept of Time Value of Money, i.e. the difference in value between the money today and the money in the future. Therefore, we need a methodology that allows to move all the future cash flows to today (t=0) or to an arbitrary future date.

In order to compare or combine cash flows, they need to be at the same point in time. Therefore, if we want to move cash flows backwards (i.e. bring them to t=0 or today) they must be¬†discounted¬†at a certain interest rate:

PV : Present Value

Cn¬†: Cash Flow at time t = n

rn¬†: Market Interest Rate for t = n

PV = Œ£ Cn¬†√∑ (1 + rn)n

In the example below, we compute the PV as follow (assume that r is constant interest rate and equal to 3%):

PV = $ 1000 √∑ (1 + 0.03)0¬† +¬† $ 1000 √∑ (1 + 0.03)1¬† +¬† $ 1000 √∑ (1 + 0.03)2¬† +¬† $ 1000 √∑ (1 + 0.03)3¬†¬†+¬† $ 1000 √∑ (1 + 0.03)4¬†¬†¬†+¬† $ 1000 √∑ (1 + 0.03)‚Ä¶¬†¬†+¬† $ 1000 √∑ (1 + 0.03)N

What‚Äôs the different between present value and future value?

The future value is the result obtained by the doing the opposite operation of discounting, which is called¬†compounding. That is necessary when we want to move our cash flows to time t=N:

FV : Future Value

Cn¬†: Cash Flow at time t = n

rn¬†: Market Interest Rate for t = n

FVN¬†= C0¬†¬†(1 + r)N

That is:

FVN¬†= $ 1000 (1 + 0.03)N