Difference Between PV and NPV
Present value (PV) refers to the present value of all future cash inflows in the company during a particular period of time whereas net present value (NPV) is the value derived by deducting the present value of all the cash outflows of the company from the present value of the total Cash inflows of the company.
What is Present Value (PV)?
PV or Present Value is the sum of all future cash flows discounted at a specific rate of return. Present value is also known as a discounted value, and it helps in determining the fair value of future revenues or liability. The calculation of present value is a very important concept in finance and is also used in calculating the valuations of a company. This concept is also important in determining the price of the bond, spot rates, value of annuities, and also for the calculation of pension obligations. Calculating the present value helps in determining how much do you need to fulfill a future goal like buying a house or paying tuition fees. It also helps you calculate if you should buy a car on EMI or pay the mortgage
The present value is calculated using the equation:
where
- FV is the future value
- r is the required rate of return, and n is the number of periods.
The higher the rate, the lower the return. This is because the cash flows are discounted at a higher rate
We want to know the present value of $100 in one year, of which the discount rate is 10%
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- Present Value = 100/(1+10%)^{1 }= $91
What is Net Present Value (NPV)?
NPV, or net present value, is the summation of all present values of a series of payments and future cash flows. NPV provides a method for comparing products that have cash flows spread across years. This concept can be used in loans, payouts, investments, and many other applications. The net present value is the difference between today’s expected cash flows and today’s value of cash investment.
It is also an important concept in capital budgeting. It a complex and comprehensive way to calculate and to understand if a project is financially viable. This concept includes many other financial concepts like cash flows, required return (weighted average cost of capital), terminal value, time value of money, and salvage value
A positive present value means that the company is generating revenues more than its expenses and making a profit. It is considered that if the company estimates that a project has a positive net present value, then the project is assumed to be profitable, and a project with negative cash flows is assumed to be loss-making.
Net present value can be calculated using the formula.
Where R_{1 }= Net Cash flow in period one, R_{2 }= Net Cash flow in period two, R_{3}= Net Cash flow in period three, and i = the discount rate
Assume that a company buys a machine for $1000, which generates cash flows of $600 in year one, $550 in year two, $400 in year three, and $100 in year four. Calculate the net present values assuming a discount rate of 15%
- NPV = [ $600/(1+15)^{1} + $550/(1+15)^{2} + $400/(1+15)^{3} + $100/(1+15)^{4} ] – $1000
- NPV = $257.8
PV vs NPV Infographics
Key Difference
- Present value or PV is the addition of all the future cash inflows given at a particular rate. On the other hand, the Net present value is the difference between the cash flows earned at the various period and the initial investment required to finance
- Present value helps in making investment decisions for cars or to calculate the value of the liabilities, investment decisions related to bonds, spot rates, etc. On the other hand, the net present value is mainly used by companies in evaluating capital budgeting decisions. An important point to note here is that it is assumed that every project with a positive net present value is profitable. For a company that has unlimited sources of cash, it can only make such decisions; such a scenario is not possible in the real world. Projects with the highest NPV are selected by a company along with using other metrics like IRR (internal rate of return), PB (payback period), DPB (discounted payback period)
- The calculation of Present value is simply discounting the future cash flow by the required rate of return for a required period. Net present value is, however, more complex, and takes into account cash flows at different periods.
- Net present value helps in calculating profitability while the present value does not help in calculating wealth creation or profitability.
- Net present value accounts for the initial investment required to calculate the net figure while the present value only accounts for cash flow.
- It is very important to understand the concept of Present value; however, the concept of net present value is more comprehensive and complex.
PV vs NPV Comparative Table
Basis |
Present Value | Net Present Value | ||
Definition | Present Value calculates the discounted cash flows of all the revenues estimated to generate in a project. | The net present value calculates how profitable a project is after calculating the initial investment required. | ||
Measure | It measures the value of future cash flows today. | It measures the value of a project. If the company should undertake the project or not | ||
Wealth Creation | The present value gives an absolute number and does not measure the additional wealth created. | NPV calculates the additional wealth generated by calculating the profitability of the project | ||
Acceptance | PV method is simple and understood by the general public and can be used in their daily decision-making process. | Net present value is used mainly by business managers and helps in capital budgeting decisions. | ||
Cash Flow | PV calculates the current value of Cash Inflow, which is generated for a particular period. | NPV knocks out cash inflow with cash outflow for decision making the purpose |
Conclusion
Present value is the stepping stone to understand the concept of net present value. The application of both these concepts is very important in the decision-making process for an individual and the company. However, other concepts, along with these two, will help the investor or the business manager take more informed decisions.
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